---

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UNITED STATES SECURITIES AND EXCHANGE
COMMISSION WASHINGTON, D.C. 20549

# F O R M 20  F

|o | REGISTRATION
STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------------

OR

|x | ANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
               1934 For the fiscal year ended December 31, 2005
|- | -----------------------------------------------------------------------------------------------------------------------------------------------

OR

|o | TRANSITION
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------

OR

|o | SHELL
COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | -------------------------------------------------------------------------------------------

Date of event requiring this shell
company report..................

For the transition period
from ________ to ________

Commission file number:
005-52583



BLUEPHOENIX SOLUTIONS
LTD. (Exact Name of
Registrant as Specified in Its Charter)

Israel 
(Jurisdiction of
Incorporation or Organization)

8 Maskit Street,
Herzlia 46120, Israel 
(Address of Principal
Executive Offices)

Securities
registered or to be registered pursuant to Section 12(b) of the Act: 
None

Securities registered
or to be registered pursuant to Section 12(g) of the Act: 
Ordinary shares, NIS 0.01
par value 
(Title of Class)

Securities for which
there is a reporting obligation pursuant to Section 15(d) of the Act: 
Ordinary shares,
NIS 0.01 par value 
(Title of Class)

Indicate the number of outstanding
shares of each of the issuers classes of capital or common stock as of December 31,
2005:

13,559,838 Ordinary
shares, NIS 0.01 per share

Indicate by check mark if the
registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

Yes o No x



---

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If this report is an annual or
transition report, indicate by check mark if the registrant is not required to file
reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

Yes o No x

Note  Checking the box above
will not relieve any registrant required to file reports pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934 from their obligations under those Sections.

Indicate by check mark whether the
registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.

Yes x No o

Indicated by check mark whether the
registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.
See definition of accelerated filer in Rule 12b-2 of the Exchange Act. (Check
one):

|                          |                     |                        
|------------------------- | ------------------- | -----------------------
|Large accelerated filer o | Accelerated filer o | Non-accelerated filer x

Indicate by check mark which
financial statement item the registrant has elected to follow.

Item 17 o Item 18 x

If this is an annual report, indicate
by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act).

Yes o No x

ii

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# TABLE OF CONTENTS

|         |                                                            |   
|-------- | ---------------------------------------------------------- | --
|
|
|
|
|P A R T  | I                                                          | 1 
|ITEM 1.  | IDENTITY OF DIRECTORS, SENIOR MANAGEMENT, AND ADVISERS     | 2 
|ITEM 2.  | OFFER STATISTICS AND EXPECTED TIMETABLE                    | 2 
|ITEM 3.  | KEY INFORMATION                                            | 2 
|A.       | Selected Financial Data                                    | 2 
|B.       | Capitalization and Indebtedness                            | 3 
|C.       | Reasons for the Offer and Use of Proceeds                  | 3 
|D.       | Risk Factors                                               | 4 
|ITEM 4.  | INFORMATION ON THE COMPANY                                 | 19
|A.       | History and Development of the Company                     | 19
|B.       | Business Overview                                          | 20
|C.       | Organizational Structure                                   | 38
|D.       | Property, Plants and Equipment                             | 39
|ITEM 4A. | UNRESOLVED STAFF COMMENTS                                  | 40
|ITEM 5.  | OPERATING AND FINANCIAL REVIEW AND PROSPECTS               | 40
|A.       | Operating Results                                          | 47
|B.       | Liquidity and Capital Resources                            | 51
|C.       | Research and Development, Patents and Licenses             | 58
|D.       | Trend Information                                          | 58
|E.       | Off-Balance Sheet Arrangements                             | 59
|F.       | Tabular Disclosure of Contractual Obligations              | 59
|G.       | Safe Harbor                                                | 59
|ITEM 6.  | DIRECTORS, SENIOR MANAGEMENT, AND EMPLOYEES                | 60
|A.       | Directors and Senior Management                            | 60
|B.       | Compensation                                               | 62
|C.       | Board Practices                                            | 63
|D.       | Employees                                                  | 69
|E.       | Share Ownership                                            | 70
|ITEM 7.  | MAJOR SHAREHOLDERS AND RELATED PARTY TRANSACTIONS          | 72
|A.       | Major Shareholders                                         | 72
|B.       | Related Party Transactions                                 | 74
|C.       | Interests of Expert and Counsel                            | 77
|ITEM 8.  | FINANCIAL INFORMATION                                      | 78
|A.       | Consolidated Statements and Other Financial Information    | 78
|B.       | Significant Changes                                        | 78
|ITEM 9.  | THE OFFER AND LISTING                                      | 79
|A.       | Offer and Listing Details                                  | 79
|B.       | Plan of Distribution                                       | 80
|C.       | Markets                                                    | 80
|D.       | Selling Shareholders                                       | 80
|E.       | Dilution                                                   | 81
|F.       | Expenses of the Issue                                      | 81
|ITEM 10. | ADDITIONAL INFORMATION                                     | 81
|A.       | Share Capital                                              | 81
|B.       | Memorandum and Articles of Association                     | 81
|C.       | Material Contracts                                         | 84
|D.       | Exchange Controls                                          | 86
|F.       | Dividend and Paying Agents                                 | 94
|G.       | Statement by Agents                                        | 94
|H.       | Documents on Display                                       | 94
|I.       | Subsidiary Information                                     | 95
|ITEM 11. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK | 95
|ITEM 12. | DESCRIPTION OF SECURITIES OTHER THAN EQUITY SECURITIES     | 95

iii

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|          |                                                                              |   
|--------- | ---------------------------------------------------------------------------- | --
|
|
|
|
|P A R T   | II                                                                           | 96
|ITEM 13.  | DEFAULTS, DIVIDEND ARREARAGES AND DELINQUENCIES                              | 96
|ITEM 14.  | MATERIAL MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS | 96
|ITEM 15.  | CONTROLS AND PROCEDURES                                                      | 96
|ITEM 16A. | AUDIT COMMITTEE FINANCIAL EXPERT                                             | 96
|ITEM 16B. | CODE OF ETHICS                                                               | 96
|ITEM 16C. | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                       | 97
|ITEM 16D. | EXEMPTIONS FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES                   | 98
|ITEM 16E. | PURCHASES OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS       | 98
|         
|P A R T   | III                                                                          | 99
|ITEM 17.  | FINANCIAL STATEMENTS                                                         | 99
|ITEM 18.  | FINANCIAL STATEMENTS                                                         | 99
|ITEM 19.  | EXHIBITS                                                                     | 99

iv

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# P A R T I

---

Some
of the statements in this annual report, including those in the Risk Factors, Operating
and Financial Review and Prospects, and Business Overview sections, are forward-looking
statements that involve risks and uncertainties. These forward-looking statements include
statements about our plans, objectives, strategies, expectations, intentions, future
financial performance, and other statements that are not historical facts. We use words
like anticipates, believes, expects,
future, intends, and similar expressions to mean that the
statement is forward-looking. You should not unduly rely on these forward-looking
statements, which apply only as of the date of this annual report. Our actual results
could differ materially from those anticipated in the forward-looking statements for many
reasons, including the risks described under Risk Factors.

As
used in this annual report, references to we, our,
ours, and us refer to BluePhoenix Solutions Ltd. and its
subsidiaries, unless otherwise indicated. References to BluePhoenix refer to
BluePhoenix Solutions Ltd.

The
name BluePhoenix and the names BluePhoenix IT Discovery, BluePhoenix
LogicMiner, BluePhoenix WS4Legacy, BluePhoenix DBMSMigrator, BluePhoenix
PlatformMigrator, BluePhoenix LanguageMigrator, BluePhoenix DataMigrator,
BluePhoenix FieldEnabler, BluePhoenix StandardsEnabler, BluePhoenix
COBOL/LE-Enabler, BluePhoenix GTIN/UPCEnabler, BluePhoenix EuroEnabler,
BluePhoenix LiraEnabler, BluePhoenix Nebula, BluePhoenix AppBuilder, and
BluePhoenix ReBuilder appearing in this annual report are trademarks of our company.
Other trademarks in this annual report are owned by their respective holders.

1

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|ITEM 1. | IDENTITY
OF DIRECTORS, SENIOR MANAGEMENT, AND ADVISERS
|------- | ------------------------------------------------------

Not applicable.

|ITEM 2. | OFFER
STATISTICS AND EXPECTED TIMETABLE
|------- | ---------------------------------------

Not applicable.

|ITEM 3. | KEY
INFORMATION
|------- | ---------------

|A. | Selected
Financial Data
|-- | -----------------------

The
following tables present our consolidated statement of operations and balance sheet data
for the periods and as of the dates indicated. We derived the statement of operations data
for each of the years ended December 31, 2003, 2004 and 2005 and the balance sheet
data as of December 31, 2004 and 2005 from our consolidated financial statements included
in Item 18 of this annual report, which have been prepared in accordance with generally
accepted accounting principles as applied in the United States, or U.S. GAAP. Our
consolidated financial statements have been audited by Ziv Haft
registered public accountant (Isr.) BDO member firm. The selected consolidated financial
data as of December 31, 2001, 2002 and 2003 and for the years ended December 31, 2001
and 2002 is derived from our audited financial statements not included in this annual
report, which have been prepared in accordance with U.S. GAAP. You should read the
selected consolidated financial data set forth below together with our consolidated
financial statements included elsewhere in this annual report. See Item 5. Operating
and Financial Review and Prospects.

2

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|                                                       | Year Ended December 31,
|------------------------------------------------------ | -----------------------
|
|
|
|
|Revenues                                               |                        
|Cost of revenues                                       |                        
|                                                       |                        
|Gross profit                                           |                        
|Software development costs                             |                        
|Selling, general, and administrative expenses          |                        
|                                                       |                        
|                                                       |                        
|Goodwill impairment, restructuring costs, and          |                        
|non-recurring expenses                                 |                        
|                                                       |                        
|Operating income (loss)                                |                        
|Financial income (expenses), net                       |                        
|Gain on realization of shareholdings                   |                        
|Other income (expenses), net                           |                        
|                                                       |                        
|Income (loss) before taxes on income                   |                        
|Income tax expense                                     |                        
|                                                       |                        
|                                                       |                        
|Equity in losses of affiliated companies, net          |                        
|Minority interest                                      |                        
|                                                       |                        
|Net income (loss)                                      |                        
|                                                       |                        
|                                                       |                        
|Basic earning (loss) per share                         |                        
|Diluted earnings (loss) per share                      |                        
|                                                       |                        
|Weighted average number of shares outstanding          |                        
|Weighted average number of shares outstanding assuming |                        
|dilution                                               |                        

|                     | December 31,
|-------------------- | ------------
|
|
|
|
|Working capital      |             
|Total assets         |             
|Total liabilities    |             
|Shareholders' equity |             

|B. | Capitalization
and Indebtedness
|-- | -------------------------------

Not applicable.

|C. | Reasons
for the Offer and Use of Proceeds
|-- | -----------------------------------------

Not applicable.

3

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|D. | Risk
Factors
|-- | ------------

Our
business, operating results, and financial condition could be seriously harmed due to any
of the following risks. In addition, the trading price of our ordinary shares and
convertible notes could decline due to any of these risks. Additional risks and
uncertainties that we are not aware of or that we currently believe are immaterial may
also adversely affect our business, financial condition, results of operations and our
liquidity.

Risks Related to Our
Business

If capital spending on information
technology, or IT, slows down, our business could be seriously harmed.

We
are affected by global economic changes, in particular trends in capital spending in the
IT sector. During 2001 through 2003, the overall business slowdown in the North American
and European markets influenced the purchasing patterns of leading software developers
who delayed their planned orders and caused developers to reduce the amount of their
planned license commitment. These changes in purchasing patterns in the IT industry
directly affected our operating results. Although we believe that during the last two
years the IT market has begun to recover, we cannot know whether the global market
recovery will continue in the future, and how the economic conditions will continue to
affect our business. Accordingly, we cannot assure you that we will be able to increase
our revenues or keep our revenues at the same level as in 2004 and 2005.

Any future acquisitions of
companies or technologies may distract our management and disrupt our business.

As
part of our growth strategy, we have been investing in and acquiring control of various
companies to expand our solution portfolio. We intend to continue seeking investment
opportunities. In addition, as part of our expansion strategy, we increased our
controlling interest in some of our subsidiaries and fully integrated them within our
business. We cannot assure you that we will be able to identify future suitable
acquisition or investment candidates or, if we do identify suitable candidates, that we
will be able to make the acquisitions or investments on commercially acceptable terms or
at all. If we acquire, invest in, or increase our control interest in another company, we
could have difficulty assimilating that companys personnel, operations, technology,
or products and service offerings into our own. In addition, the key personnel of the
acquired company may decide not to work for us. These difficulties could disrupt our
ongoing business, distract our management and employees, increase our expenses, and
adversely affect our results of operations. Acquisitions of new companies also involve
the risk of penetrating markets in which we have no or limited experience. We may incur
indebtedness or issue equity securities to pay for any future acquisitions. The issuance
of equity securities could be dilutive to our existing shareholders.

4

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We have a limited operating
history in our current principal markets, which will make it difficult or impossible for
you to predict our future results of operations.

We
have experienced major fluctuations in our net results. In 2005, 2004 and 2003, we had
net income of $1.8 million, $2.8 million and $1.9 million, respectively. However, in 2002
and 2001 we had a net loss of $3.6 million and $15.0 million, respectively. The net loss
in 2002 and 2001 was a reversal from prior years in which we had net income. The
fluctuations in our net results are mainly attributable to the changes in the suite of
modernization tools we have been offering to our customers, the limited experience we
have had in the markets for these tools, and the difficulties we have encountered in
introducing our tools to their respective markets. In addition, global economic
conditions affect our net results. Most of the solutions we offer to our customers are
based on tools that share a common generic technology and methodology. However, the
introduction of new tools to new markets involves increased selling and marketing
expenses, which in turn increases our operating expenses and directly affects our results
of operations. Because of our limited experience in our principal markets and with our
new products, we cannot assure you that our strategy for operating in these markets or
selling these products will be successful. You should not rely on our historical results
of operations as indications of future performance.

If we are unable to accurately
predict and respond to market developments or demands, our business will be adversely
affected.

The
IT modernization business is characterized by rapidly evolving technology and
methodologies. This makes it difficult to predict demand and market acceptance for our
modernization tools and services. In order to succeed, we need to adapt the tools and
services we offer to keep up with technological developments and changes in customer
needs. We cannot guarantee that we will succeed in enhancing our tools and services or
developing or acquiring new modernization tools and services that adequately address
changing technologies and customer requirements. We also cannot assure you that the tools
and services we offer will be accepted by customers. If our tools and services are not
accepted by customers, our future revenues and profitability will be adversely affected.
Changes in technologies, industry standards, the regulatory environment, customer
requirements, and new product introductions by existing or future competitors could render
our existing solutions obsolete and unmarketable, or require us to enhance our current
tools or develop new tools. This may require us to expend significant amounts of money,
time, and other resources to meet the demand. This could strain our personnel and
financial resources.

We may experience significant
fluctuations in our annual and quarterly results, which makes it difficult for our
shareholders and noteholders to make reliable period-to-period comparisons and may
contribute to volatility in the market price of our ordinary shares and convertible notes.

Our
quarterly and annual results of operations have fluctuated significantly in the past and
we expect them to continue to fluctuate significantly in the future. These fluctuations
are the result of risks related to the introduction of new products as described above and
any of the following events:

5

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| |  | adverse
economic conditions in various geographic areas where our customers and potential
customers operate;
| | - | ------------------------------------------------------------------------------------------------------------

| |  | acquisitions
and dispositions of companies;
| | - | -------------------------------------------

| |  | timing
of completion of specified milestones and delays in implementation;
| | - | --------------------------------------------------------------------------

| |  | timing
of product releases;
| | - | ---------------------------

| |  | timing
of contracts;
| | - | --------------------

| |  | increases
in selling and marketing expenses, as well as other operating expenses; and
| | - | -------------------------------------------------------------------------------------

| |  | currency
fluctuations.
| | - | ----------------------

In
addition, unexpected events that do not occur on a regular basis and that are difficult to
predict may cause fluctuations in our operating results. As a result, we believe that
period-to-period comparisons of our historical results of operations are not necessarily
meaningful and that you should not rely on them as an indication for future performance.
Also, it is possible that our quarterly and annual results of operations may be below the
expectations of public market analysts and investors.

A delay in collection of our fees
could result in cash flow shortages, which in turn may significantly impact our financial
results.

Typical
modernization projects, which deploy our solutions, are long-term projects, and therefore,
payment for these projects or a substantial portion of our fees may be delayed until the
successful completion of specified milestones. In addition, the payment of our fees is
dependent upon customer acceptance of the completed work, and our ability to collect the
fees. Further, although the timing of receipt of our fees varies, we incur the majority of
our expenses on a current basis. As a result, a delay in the collection of our fees could
result in cash flow shortages. To date, we have not experienced any significant payment
delays that resulted in cash flow shortages. Any significant variation in estimated and
actual revenues obtained may significantly impact our financial results in any given
period.

The ability of our subsidiary,
Mainsoft, to continue marketing the cross-platform products for the Unix environment
(Visual MainWin for Unix and Linux) is dependent upon Mainsoft maintaining current
relationship with Microsoft providing Mainsoft with distribution rights and access rights
to Microsofts source code.

Pursuant
to a Windows source-code agreement entered into between our subsidiary, Mainsoft
Corporation, referred to as Mainsoft, and Microsoft in 1998, and the amendments thereto,
Microsoft granted Mainsoft access to specified Microsoft source code for C/C++
development. Our revenues relating to the Visual MainWin product depend on the
availability of Windows source-code under this license agreement. While Mainsoft believes
its relationship with Microsoft will continue on terms acceptable to us, a change in the
relationship could adversely affect our business, results of operations, and financial
condition.

6

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Under
the license agreement between Mainsoft and Microsoft, Mainsoft may request that Microsoft
waive certain Microsoft royalties for particular customers. In the past, Microsoft
generally has granted these customers specific royalty waivers. However, we cannot assure
you that Microsoft will continue to grant such waivers. An increase in royalties would
require us to raise the prices of specific products or reduce our gross margins, either of
which could harm our business.

On
February 13, 2004, there were public reports that Microsoft source code had leaked on the
Internet. These reports indicated that the source code contained trace references to the
Mainsoft servers and personnel. Mainsofts management team fully cooperated with
local authorities, the FBI, and Microsoft in their respective investigations. All parties
conducting investigations have found no trace of a security breach after that date.
Although we have been notified in 2004 that the investigation has not yet been completed,
we have not received any update from the FBI since then.

Mainsofts dependency on
Microsoft .NET, an open-source implementation of Microsoft.

Mainsofts
Visual MainWin for J2EE has been developed based on the open-source Mono project led by
Novell, which is an open-source implementation of the Microsoft .NET framework. Microsoft
may claim that software developed based on the open-source Mono project infringes certain
Microsoft patents. Microsoft may cease its business relationship and cooperation with
companies using the open source Mono project, which may result in severe damage to
Mainsofts ability to effectively market the Visual MainWin for J2EE product.

Damage
to Mainsofts relationship with Microsoft could have a material adverse effect on our
business, financial condition, and results of operations.

If we fail to address the strain
on our resources caused by changes in our company, we will be unable to effectively manage
our business.

In
the past few years, we have undergone significant changes in our product offerings. These
changes include acquiring new technologies, developing and marketing new modernization and
porting tools and expanding the sales of our products further into international markets.
This has placed and will continue to place substantial demands upon our management,
systems, and resources, including our sales, project management, consulting personnel, and
software development operations. Our ability to manage any future changes or growth
depends on our ability to continue to implement and improve our operational, financial,
and management information control and reporting systems on a timely basis, and to expand,
train, motivate, and manage our work force. If we cannot respond effectively to changing
business conditions, our business, financial condition, and results of operations could be
materially adversely affected.

7

---

---



If we are unable to manage the
effects of the variations in our offering portfolio, our results will be adversely
affected.

We
specialize in the development and implementation of sophisticated software modernization
and porting tools and products. We leverage our know-how, experience and generic
technologies, to develop and introduce new software tools that enable the modernization of
legacy systems. The need for our modernization solutions changes over time, and recent
regulations or newly introduced technologies may create new needs for modernization
solutions. As part of our growth strategy, as a new need evolves, we typically conduct a
market analysis to qualify and quantify the market opportunity. If the results justify the
investment required for the development of new products or tools, then we begin the
development process of the new product. In order to maintain our position in the market,
and our ability to address the constantly changing needs of the marketplace, we
continually invest in the development of new products. The net annual expense related to
research and development was approximately $8 million during each of the last three years.

In
order to properly introduce a new product to the marketplace or to introduce our current
products into new markets, we continuously update our marketing materials, educate our
sales force and make changes to our operations. If these activities are not completed in a
timely manner, our new product introduction may be delayed.

If we are unable to attract,
train, and retain qualified personnel, we may not be able to achieve our objectives and
our business could be harmed.

In
order to achieve our objectives, we may need to hire additional, qualified software,
administrative, operational, sales, and technical support personnel. The process of
attracting, training, and successfully integrating qualified personnel can be lengthy and
expensive. We may not be able to compete effectively for the personnel we need. As part of
our growth strategy, we developed offshore centers in Cyprus and Romania. We hired
professional consultants for these development centers, leveraging the lower employer
costs in these countries. Our future success depends on our ability to absorb and retain
senior employees and to attract, motivate, and retain highly qualified professional
employees worldwide.

If we fail to estimate accurately
the costs of fixed-price contracts, we may incur losses.

We
derive a portion of our revenues from engagements on a fixed-price basis. We price these
commitments upon estimates of future costs. We bear the risk of faulty estimates and cost
overruns in connection with these commitments. Our failure to accurately estimate the
resources required for a fixed-price project, to accurately anticipate potential wage
increases, or to complete our contractual obligations in a manner consistent with the
project plan could materially adversely affect our business, operating results, and
financial condition. In addition, we may agree to a price before the design specifications
are finalized, which could result in a fixed price that is too low, resulting in lower
margins or losses to us.

If our tools or solutions do not
function efficiently, we may incur additional expenses.

In
the past years, we have successfully used our software modernization tools in numerous
software projects. In the course of providing our modernization solutions, the project
team conducts testing to detect the existence of failures, errors and bugs. In addition,
we have instituted a quality assurance procedure for correcting errors and bugs in our
tools. The amount of failures, errors, and bugs detected in modernization projects to
date, and the cost of correcting them, has not been significant. However, if our
modernization solutions fail to function efficiently or if errors or bugs are detected in
our tools, we might incur significant expenditures in an attempt to remedy the problem.
The consequences of failures, errors, and bugs could have a material adverse effect on our
business, operating results, and financial condition.

8

---

---



If we fail to satisfy our
customers expectations regarding our solutions, our contracts may be cancelled and
we may be the subject of damages claims.

In
the event that we fail to satisfy our customers expectations from the results of the
implementation of our solutions, or if we fail to timely deliver our solutions to our
customers, these customers may suffer damages. When and if this occurs, customers may have
the ability to cancel our contracts. Any cancellation of a contract could cause us to
suffer damages, since we might not be paid for costs that we incurred in performing
services prior to the date of cancellation. In addition, from time to time we may be
subject to claims as a result of not delivering our products on time or in a satisfactory
manner. Such disputes or others may lead to material damages.

We are exposed to significant
claims for damage caused to our customers information systems.

Some
of the products, tools, and services we provide involve key aspects of our customers
information systems. These systems are frequently critical to our customers
operations. As a result, our customers have a greater sensitivity to failures in these
systems than do customers of other software products generally. We have never been the
subject of a material damages claim related to our modernization solutions or
modernization services. However, if a customers system fails during or following the
provision of modernization solutions or services by us, or if we fail to provide customers
with proper support for our modernization solutions, we are exposed to the risk of a claim
for substantial damages against us, regardless of our responsibility for the failure. When
possible, we limit our liability under our product and service contracts. However, we
cannot guarantee that these limitations of liability, if any, would be sufficient to
protect us against legal claims. We maintain professional errors and omissions and general
liability insurance coverage. However, we cannot assure you that our insurance coverage
will be sufficient to cover one or more large claims, or that the insurer will not
disclaim coverage as to any future claim. If we lose one or more large claims against us
that exceed available insurance coverage, it may have a material adverse effect on our
business, operating results, and financial condition. In addition, the filing of legal
claims against us in connection with contract liability may cause us negative publicity
and damage to our reputation.

If third parties assert claims of
infringement against us, we may suffer substantial costs and diversion of
managements attention.

Substantial
litigation over intellectual property rights exists in the software industry. Software
products may be increasingly subject to third-party infringement claims as the
functionality of products in different industry segments overlaps. Although our products
and services have never been the subject of an infringement proceeding, we cannot predict
whether third parties will assert claims of infringement against us. In addition, our
employees and contractors have access to software licensed by us from third parties. A
breach of the nondisclosure undertakings by any of our employees or contractors may lead
to a claim of infringement against us. Any claim, with or without merit, could:

9

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| |  | be
expensive and time-consuming to defend;
| | - | ------------------------------------------

| |  | divert
management's attention and resources; or
| | - | -----------------------------------------------

| |  | require
us to enter into royalty or licensing agreements to obtain the right to use a necessary
product or                   component.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------

Royalty
or licensing agreements, if required, may not be available on acceptable terms, if at
all.

A
successful claim of product infringement against us and our failure or inability to
license the infringed  or similar technology could have a material adverse effect on our
business, financial condition, and results of operations.

We may be unable to adequately
protect our proprietary rights, which may limit our ability to compete effectively.

Our
success and ability to compete are substantially dependent upon our internally developed
technology. Our intellectual property consists of proprietary or confidential information
that is not subject to patent or similar protection. Our employees and contractors have
direct access to our technology. In general, we have relied on a combination of technical
leadership, trade secret, copyright, and trademark law and nondisclosure agreements to
protect our proprietary know-how. Unauthorized third parties may attempt to copy or obtain
and use the technology protected by those rights. Any infringement of our intellectual
property could have a material adverse effect on our business, financial condition, and
results of operations. Policing unauthorized use of our products is difficult and costly,
particularly in countries where the laws may not protect our proprietary rights as fully
as in the United States. We have placed, and in the future may place, certain of our
software in escrow. The software may, under specified circumstances, be made available to
our customers. We have also provided our software directly to customers. This may increase
the likelihood of misappropriation or other misuse of our software.

We are exposed to litigation that
could result in considerable financial liabilities.

In
July 2003, a former Liraz shareholder filed an application with the Tel-Aviv-Jaffa
District Court to approve a claim filed by him against us, as a class action. The claim
relates to the acquisition of Liraz shares, which we completed in March 2003. The
shareholder alleges that the share price we paid to Lirazs shareholders in the
tender offer and in a subsequent mandatory purchase was lower than the fair price of Liraz
shares. The maximum amount of the claim is approximately $5.8 million in the aggregate.
Under Israeli law, the courts approval is required for the plaintiff to represent
all of the shareholders of Liraz who sold their shareholdings to us pursuant to the tender
offer and the mandatory acquisition. The plaintiff has applied for such approval in the
lawsuit. A preliminary hearing is scheduled for June 7, 2006. Based on our analysis of the
statement of claim, our management believes that the claim is without merit. However, if
we are not successful in defending this claim, we could be exposed to considerable
financial liabilities and as a result, our financial condition could be materially
adversely harmed.

10

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Our largest shareholder, Formula,
controls a majority of our ordinary shares and influences the outcome of matters that
require shareholder approval.

Formula
Systems (1985) Ltd., referred to as Formula, owns, as of March 24, 2006, 58.0%of our
outstanding ordinary shares. Therefore, Formula has the power to control the outcome of
most matters requiring shareholder approval, including the election of directors and
approval of significant corporate transactions. In addition, Dan Goldstein, a member of
our board of directors and chairman and chief executive officer of Formula, and Gad
Goldstein, the chairman of our board and a director and president of Formula, own, in the
aggregate, 755,138 ordinary shares, representing 5.5% of our outstanding ordinary shares.
These individuals have entered into agreements that require them to vote their shares as
instructed by Formula. Accordingly, Formula is deemed to beneficially own approximately
63.5%of our outstanding ordinary shares. In addition, Dan Goldstein holds, through
a wholly owned company, 50% interest in FIMIGold LP, which owns 33% of the outstanding
shares of Formula; Gad Goldstein owns 2.5% of the outstanding shares of Formula.

This
share ownership may have the effect of delaying or preventing a change in control. In
addition, potential conflicts of interest may arise in the event that we enter into
agreements or transactions with these persons. Although Israeli law imposes certain
procedures (including shareholder approval) for approval of certain related party
transactions, including certain of those between us and Formula, we cannot assure you that
these procedures will eliminate the possible detrimental effects of conflicts of interest.
All of the members of our audit committee are independent directors. The audit committee
reviews potential conflict of interest situations where appropriate. If certain
transactions are not approved in accordance with required procedures under applicable
Israeli law, these transactions may be void or voidable.

Our existing credit facilities
contain a number of restrictions and obligations that limit our operating and financial
flexibility.

Our
credit facilities contain a number of restrictive covenants that limit our operating and
financial flexibility. These covenants, among other things, restrict our ability to pledge
our assets, dispose of assets, make loans or give guarantees, make certain acquisitions
and engage in mergers or consolidations. Our credit facilities also contain covenants
regarding maintaining certain financial ratios. See Item 5.B. Liquidity and Capital
Resources  How We Have Financed Our Business.

Our
ability to continue to comply with these and other obligations depends in part on the
future performance of our business. There can be no assurance that such obligations will
not materially adversely affect our ability to finance our future operations or the manner
in which we operate our business. In particular, any noncompliance with
performance-related covenants and other undertakings of our credit facilities could result
in an acceleration of our outstanding debt under our credit facilities and restrict our
ability to obtain additional funds, which could have a material adverse effect on our
business, financial condition and results of operations.

In
some circumstances, a change of control of BluePhoenix will constitute an event of default
under our credit facilities and we could be required to repay our debts to the banks. If
this occurs, we may not have the financial resources to repay all of our outstanding debt.
This also may adversely affect the attractiveness of our company to potential large
investors.

11

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Our indebtedness and debt service
obligations may adversely affect our cash flow, cash position, net results and share
price.

We
intend to fulfill our debt service obligations from existing cash, investments and our
operations. Our indebtedness could have significant negative consequences, including,
without limitation:

| |  | requiring
the dedication of a portion of our expected cash flow to service our indebtedness,
thereby reducing the amount of our expected cash flow available for other purposes,
including funding our research and development programs and other capital expenditures;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | increasing
our vulnerability to general adverse economic conditions;
| | - | --------------------------------------------------------------------

| |  | limiting
our ability to obtain additional financing; and
| | - | --------------------------------------------------------

| |  | placing
us at a possible competitive disadvantage relative to less leveraged competitors and
competitors that have better access to capital resources.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | causing
a material offset to our results, and therefore generating decreased net profits or
increased net losses.
| | - | -----------------------------------------------------------------------------------------------------------------

# We may not be able to
make our debt payments in the future.

Our
ability to meet our debt obligations will depend on whether we can successfully implement
our strategy, as well as on financial, competitive, and other factors, including some
factors that are beyond our control. Most of our debt and credit facilities bear an
interest rate based on the LIBOR. If the LIBOR materially increases, our cash flows will
be negatively affected. If we are unable to generate sufficient cash flow from operations
to meet principal and interest payments on our debt, we may have to refinance all or part
of our indebtedness. In case we have to increase our indebtedness, the additional
financing expenses will have a negative affect on our results, which cannot be predicted.
Our ability to refinance our indebtedness will depend on, among other things:

| |  | our
financial condition at the time;
| | - | ------------------------------------

| |  | restrictions
in agreements governing our debt; and
| | - | --------------------------------------------------

| |  | other
factors, including market conditions.
| | - | -------------------------------------------

We
cannot ensure that any such refinancing would be possible on terms that we could accept or
that we could obtain additional financing. If refinancing will not be possible or if
additional financing will not be available, we may have to sell our assets under
circumstances that might not yield the highest prices, or default on our debt obligations,
which would permit our noteholders and holders of other outstanding indebtedness to
accelerate their maturity dates.

The
indenture governing the convertible notes does not restrict us from incurring additional
debt or guaranteeing indebtedness, nor does it limit the amount of indebtedness that we
can issue in the future. If we incur additional debt or liabilities, our ability to pay
our debt obligations could be adversely affected.

12

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If we fail to successfully
leverage the merger with Liraz and penetrate new markets, our operating results may be
adversely affected.

In
March 2003, we completed the acquisition of the entire outstanding share capital of Liraz
Systems Ltd., an Israeli company then publicly-traded on the Tel Aviv Stock Exchange, or
the TASE. During 2004, we completed the integration of Lirazs business within our
business and been operating as one business unit since. We expect that as a result of the
integration of our business with that of Liraz, the combined companies will be able to
realize greater operating efficiencies and will benefit from a broader product line with a
larger and more diversified marketing and support network. In addition, we anticipate that
the combination of our respective technical personnel will enhance our product development
capabilities. We cannot assure you that the integration of Lirazs business within
ours will contribute to our business to the extent anticipated.

Risks relating to
International Operations

Marketing our tools and solutions
in international markets may cause increased expenses and greater exposure to risks that
we may not be able to successfully address.

We
intend to continue to expand our international operations, which will require significant
management attention and financial resources. In order to continue to expand worldwide
sales, we need to establish additional marketing and sales operations, hire additional
personnel, and recruit additional resellers internationally. To the extent that we are
unable to do so effectively, our growth is likely to be limited and our business,
operating results and financial condition will be materially adversely affected.

|We
have generated approximately 86% of our revenues in 2005 from sales to international
customers. Additional risks inherent in our worldwide business activities generally
include:
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | currency
exchange devaluations;
| | - | -------------------------------

| |  | unexpected
changes in regulatory requirements;
| | - | ----------------------------------------------

| |  | tariffs
and other trade barriers;
| | - | ---------------------------------

| |  | costs
of localizing products for foreign countries;
| | - | ---------------------------------------------------

| |  | lack
of acceptance of localized products in European and other foreign countries;
| | - | ---------------------------------------------------------------------------------

| |  | longer
accounts receivable payment cycles;
| | - | ------------------------------------------

| |  | difficulties
in operations of management;
| | - | -----------------------------------------

| |  | potentially
adverse tax consequences;
| | - | -------------------------------------

| |  | including
restrictions on the repatriation of earnings; and
| | - | -----------------------------------------------------------

| |  | the
burdens of complying with a wide variety of European and other foreign laws.
| | - | --------------------------------------------------------------------------------

|We
cannot assure you that these factors will not have a material adverse effect on our
future international sales and, consequently, on our business, operating results and
financial condition.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

13

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Inflation, devaluation and
fluctuation of various currencies may adversely affect our results of operations,
liabilities and assets.

A
significant portion of our operations is conducted through operations in foreign
countries. As a result, we enter into transactions with customers and suppliers in local
currencies. The fluctuations in foreign currency exchange rates in countries where we
operate can adversely affect the reflection of these activities in our consolidated
financial statements.

Revenues from our operations outside
of Israel represented 86% of our revenues in 2005 and 84% of our revenues in 2004.
Fluctuations in the value of our non-dollar revenues, costs and expenses measured in
dollars could materially affect our results of operations. In addition, our balance sheet
reflects non-dollar denominated assets and liabilities, which can be adversely affected by
fluctuations in the currency exchange rates.

The
reporting currency of our consolidated financial statements is the U.S. dollar. The
functional currency of our business is the U.S. dollar. We enter, from time to time, into
forward currency exchange contracts or other arrangements in order to hedge this foreign
currency exposure. Such arrangements may not always be effective or sufficient to offset
the fluctuations in currency exchange rates. For additional information relating to the
exchange rates between different relevant currencies, see Item 5.  Our
Reporting Currency.

Fluctuations in foreign currency
values affect the prices of our products, which in turn may affect our business and
results of operations.

Most
of our worldwide sales are currently denominated in U.S. dollars and euros while our
reporting currency is the dollar. A decrease in the value of the dollar relative to
foreign currencies, in particular the euro, Danish kroner (DKK) and the NIS would make our
products more expensive and increase our operating costs and, therefore, could adversely
affect our results and harm our competitive position in the markets in which we compete.

We are subject to multiple taxing
jurisdictions. If we fail to estimate accurately the amount of income tax due in any of
these jurisdictions, our net income might be affected.

We
operate within multiple taxing jurisdictions and are subject to taxation by these
jurisdictions at rates higher than those to which we are subject in Israel. In addition,
we may be subject to audits in these jurisdictions. These audits can involve complex
issues, which may require an extended period of time to resolve. In our managements
opinion, we have made adequate provisions for income taxes for all past years. Although
our management believes that its estimates are reasonable, we cannot assure you that the
final tax outcome of these issues will not be different than those, which are reflected in
our income tax provisions. Such differences could have a material effect on our income tax
provision and net income in the period in which such outcome occurs.

14

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Risks Relating to
Operations in Israel

Political, economic, and military
conditions in Israel could negatively impact our business.

We
are incorporated under the laws of the State of Israel, and certain of our key management
personnel as well as certain of our research and development facilities are located in
Israel. Although we generate most of our revenues from international markets, we
nonetheless are influenced by the political, economic and military conditions affecting
Israel. The execution of Israels plan of unilateral disengagement from the Gaza
Strip and some parts of the West Bank and Hamas gaining a majority of the seats on
the Palestinian Legislative Council in the elections held recently in the Palestinian
Authority, may affect Israels security and the stability of the region. Major
hostilities involving Israel or the interruption or curtailment of trade between Israel
and its present trading partners could have a material adverse effect on our business,
operating results and financial condition. Furthermore, several countries restrict
business with Israeli companies. In addition, nonexempt male adult citizens of Israel,
including some of our employees, are obligated to perform military reserve duty until the
age of 40 or 45 depending on their function in the army, and are subject to being called
for active duty under emergency circumstances. While we have operated effectively under
these requirements since our incorporation, we cannot predict the full impact of such
conditions on us in the future, particularly if emergency circumstances occur. If many of
our employees are called for active duty, our operations in Israel and our business may be
adversely affected.

The tax benefits available to us
from government programs may be discontinued or reduced at any time, which would likely
increase our taxes.

We
receive tax benefits under Israeli government programs, particularly as a result of the
Approved Enterprise status of certain of our operations in Israel.
Approved Enterprise status is granted by the Israeli Investment Center of the
Ministry of Industry and Trade and entitles the company to a variety of tax incentives.
The incentives awarded to certain of our subsidiaries include reduced tax rates and a tax
holiday. We were granted a two year tax exemption, followed by a five year reduced tax
rate of 25% instead of 34% on income derived from our Approved Enterprise
investment programs. In order to qualify for these incentives, the Approved
Enterprise is required to provide minimum paid-in-capital (30% of the investment),
to show an increase in its export activities, and to meet other general investing
criteria. As of March 24, 2006, we have met those criteria and received tax benefits from
our Approved Enterprise programs, as presented in Note 14A to our financial
statements. To maintain our eligibility for these programs and benefits, we must meet the
conditions mentioned above. We cannot assure you that these programs and tax benefits will
continue at the same level in the future. If these tax benefits and programs are
terminated or reduced, we could pay increased taxes in the future, which could decrease
our profits.

15

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|It  may be difficult to serve process and enforce judgments against our directors and officers
in Israel.
|---------------------------------------------------------------------------------------------------------

nonresidents
of the United States, We are organized under the laws of the State of Israel. Most of our
executive officers and directors are and a substantial portion of our assets and the
assets of these persons are located outside the United States. Therefore, it may be
difficult to:

| |  | effect
service of process within the United States on us or any of our executive officers or
directors who are nonresidents of the United States;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------

| |  | enforce
court judgments obtained in the United States including those predicated upon the civil
liability provisions of the United States federal securities laws, against us or against
any of our executive officers or directors that are nonresidents of the United States, in
the United States or Israel; and
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | bring
an original action in an Israeli court against us or against any of our executive
officers or directors to enforce liabilities based upon the United States federal
securities laws.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Risks Related to our
Traded Securities

The market price of our
convertible notes and ordinary shares may be volatile and our investors may not be able to
resell the notes or the shares at or above the price they paid, or at all.

During
the past few years, the worldwide stock markets have experienced high price and volume
fluctuations. The market prices of securities of technology companies have been extremely
volatile, and have experienced fluctuations that have often been unrelated or
disproportionate to the operating performance of those companies. These broad market
fluctuations could adversely affect the market price of our ordinary shares. During 2003,
for example, the market price of our ordinary shares traded on the NASDAQ fluctuated
between $7.04 and $2.10. During 2004, the market price of our ordinary shares fluctuated
between $7.49 and $3.71. During 2005, the market price fluctuated between $4.75 and $3.81.
The market price of our ordinary shares may continue to fluctuate substantially due to a
variety of factors, including:

| |  | any
actual or anticipated fluctuations in our or our competitors' quarterly revenues and
operating results;
| | - | -----------------------------------------------------------------------------------------------------------

| |  | shortfalls
in our operating results from levels forecast by securities analysts;
| | - | --------------------------------------------------------------------------------

| |  | public
announcements concerning us or our competitors;
| | - | ------------------------------------------------------

| |  | the
introduction or market acceptance of new products or service offerings by us or by our
competitors;
| | - | -------------------------------------------------------------------------------------------------------

| |  | changes
in product pricing policies by us or our competitors;
| | - | -------------------------------------------------------------

| |  | changes
in security analysts' financial estimates;
| | - | --------------------------------------------------

| |  | changes
in accounting principles;
| | - | ---------------------------------

| |  | sales
of our shares by existing shareholders; and
| | - | -------------------------------------------------

| |  | the
loss of any of our key personnel.
| | - | -------------------------------------

16

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In
addition, economic, political, and market conditions and military conflicts and, in
particular, those specifically related to the State of Israel, may affect the market price
of our shares.

In
February 2006, we completed an underwritten public offering in Israel of series A
convertible notes in an aggregate principal amount of $11.5 million, referred to in this
annual report as the convertible notes. Following the offering, the convertible notes have
been listed for trading on the TASE. The trading price of the convertible notes could be
subject to significant fluctuations. The trading price of the convertible notes depends on
many factors, including but not limited to, prevailing interest rates, the trading price
of our ordinary shares, the market for similar securities and general economic conditions.
Additionally, it is possible that the market for the convertible notes will be subject to
disruptions that may have a negative effect on the holders of the convertible notes,
regardless of our prospects or financial performance.

Our ordinary shares are traded on
more than one market and this may result in price variations.

Our
ordinary shares trade on the NASDAQ National Market and the TASE. Trading in our ordinary
shares on these markets take place in different currencies (dollars on the NASDAQ National
Market and NIS on the TASE), and at different times (resulting from different time zones,
different trading days and different public holidays in the United States and Israel). The
trading prices of our ordinary shares on these two markets may differ due to these and
other factors. Any decrease in the trading price of our ordinary shares on one of these
markets could cause a decrease in the trading price of our ordinary shares on the other
market.

Future sales of our shares to be
registered for resale in the public market could cause the market price for our ordinary
shares or convertible notes to fall.

As
of March 24, 2006, we had 13,842,079 ordinary shares outstanding (excluding 1,647,594 held
by two of our wholly owned subsidiaries). In addition, we have reserved 2,758,167 ordinary
shares for issuance under our option plans. We also have certain commitments described
below to issue BluePhoenix ordinary shares and register them for resale, as follows:

| |  | 210,000
ordinary shares underlying warrants issued to First Israel Mezzanine Investors Ltd.,
known as FIMI;
| | - | -----------------------------------------------------------------------------------------------------------

| |  | 1,239,912
ordinary shares issuable upon conversion of debentures and exercise of warrants issued to
four                   institutional investors in connection with the $5 million private
placement completed in March                   2004. For more information, see "Item 5.B
Liquidity and Capital Resources - Contractual                   Commitments and
Guarantees;"
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 100,000
ordinary shares underlying options issued to Israel Infinity Venture Capital Partners
Ltd., referred to as Infinity, and an additional amount of shares to be calculated in
accordance with the terms of the agreement with Infinity entered into in April 2004. For
more information, see  Item 4.B Business Overview  Investments and
Acquisitions;"
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

17

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| |  | 2,047,101
ordinary shares issuable upon conversion of the convertible notes traded on the TASE sold
by us in a public offering in Israel in February 2006. For more information about these
rights, see  Item 7.B Related Party Transactions  Registration Rights
Agreements, Voting Agreement; and
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | 866,667
ordinary shares issuable upon conversion of debentures and exercise of warrants issued to
three institutional investors in connection with the $3 million follow-on private
placement completed on March 23, 2006. We are obligated to file a registration statement
within 45 days from the closing. For more information, see Item 5.B Liquidity and
Capital Resources  Contractual Commitments and Guarantees.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

In
addition, certain of our shareholders, holding in the aggregate 10,186,401 ordinary
shares, have registration rights with respect to the shares they hold, including piggyback
rights. For more information about these rights, see Item 7.B Related Party
Transactions  Registration Rights Agreements, Voting Agreement.

If
a large number of our ordinary shares are sold in a short period, the price of our
ordinary shares would likely decrease.

In
addition, the price of our ordinary shares could be affected by possible sales of our
ordinary shares by investors who view the convertible notes as a more attractive means of
equity participation in our company and by hedging or arbitrage trading activity that may
develop involving our ordinary shares. The hedging or arbitrage could, in turn, affect the
trading prices of the convertible notes.

Conversion of the convertible
notes and other convertible securities, as well as exercise of warrants held by certain
investors, would dilute the ownership interest of our existing shareholders.

The
conversion of some or all of the convertible notes traded on the TASE, the convertible
debentures held by the institutional investors and the exercise of options and warrants
held by investors, would dilute the ownership interests of our existing shareholders. Any
sales in the public market of our ordinary shares issuable upon such conversion could
adversely affect the prevailing market prices of our ordinary shares.

18

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|ITEM 4. | INFORMATION
ON THE COMPANY
|------- | --------------------------

|A. | History
and Development of the Company
|-- | --------------------------------------

We
were incorporated in Israel in 1987 under the name A. Crystal Solutions Ltd. In 1996, we
changed our name to Crystal Systems Solutions Ltd. In 2003, following the acquisition of
Liraz Systems Ltd., we changed our name to BluePhoenix Solutions Ltd. Our registered
office is located at 8 Maskit Street, Herzlia, 46120 Israel and our telephone number is
972-9-9526110. Our agent in the United States isBlue Phoenix Solutions USA Inc.,
8000 Regency Parkway, Cary, NC 27511 United States and its telephone number is (919)
380-5100.

We
run our worldwide operations through several wholly owned subsidiaries, named below:

| | Name of Subsidiary                   | Country of Incorporation
| | ------------------------------------ | ------------------------
|
|
|
|
| | BluePhoenix Solutions USA Inc.       |                         
| | IntraComp Group Inc.                 |                         
| | BluePhoenix Solutions Nordic ApS     |                         
| | BluePhoenix Solutions U.K. Ltd.      |                         
| | BluePhoenix Solutions Srl            |                         
| | I-Ter/Informatica & Territorio S.p.A |                         
| | BluePhoenix Solutions GmbH           |                         
| | BluePhoenix Solutions B.V            |                         
| | BluePhoenix Solutions Ltd.           |                         
| | BluePhoenix Solutions Srl            |                         

For
information about our significant subsidiaries, see Item 4.C  Organizational
structure.

Recent
Developments

In
February 2006, we completed an underwritten public offering in Israel of series A
convertible notes in an aggregate principal amount of $11.5 million. The price of the
notes as determined in the offering was 98% of the principal amount of the notes, and the
gross proceeds from the offering were $11.2 million. The notes bear an interest at a rate
of LIBOR 3 months +1.5% per annum, payable every 3 months beginning on May 1, 2006, with
the last payment to be made on February 1, 2011. The principal of the notes is payable in
four equal annual installments on February 1 of each of 2008 through 2011. Under certain
terms, we may call for an early redemption of the notes, after February 1, 2008. The notes
are convertible into our ordinary shares of BluePhoenix at a conversion rate of one
ordinary share per $5.52 principal amount of notes, subject to adjustments. Holders may
convert their notes into BluePhoenixs ordinary shares on any trading day, beginning
on the date the notes were first listed for trading and until the close of trading on
January 16, 2011, except for certain specified days. The convertible notes are not
secured.

19

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The
notes are traded on the TASE. The Israeli Securities Authority and the TASE approved the
listing of the shares underlying the notes for trading on the TASE. The notes and the
shares underlying the notes have not been registered under the Securities Act, and may not
be offered or sold in the United States or to U.S. persons, absent registration or an
applicable exemption from registration requirements. For more information about our
capital expenditures, see Item 5.B. Liquidity and Capital Resources  Capital
Expenditures.

|B. | Business
Overview
|-- | -----------------

Our Business

We
develop and market unique enterprise IT modernization, or EIM, solutions that enable
companies to automate the process of modernizing and upgrading their mainframe and
distributed IT infrastructure and to effectively compete in todays environment. The
combination of our comprehensive tools and services with our unique methodology provides
an efficient and cost-effective process for extending the return on investment of existing
enterprise IT assets. Our complete modernization solutions consist of a combination of
automated technologies and services that minimize the risk through the whole life cycle of
the process. Our solutions are based on technologies for Understanding, Migration,
Remediation, and Redevelopment, allow companies to fully leverage their current systems
and applications, speed up and reduce the cost of the renewal process, and effectively
update their systems in order to adapt to new business demands. In addition, by using our
technologies organizations gain the added value of extending their systems to be ready for
future demands, such as service oriented architecture, or SOA. Our modernization solutions
are offered to customers in all business market sectors, particularly financial services,
banking, insurance and automotive.

Our
solution portfolio includes software products, software tools, and services that address
the most pressing challenges organizations and companies face today.

Our
solutions enable companies to:

| |  | better
understand and manage their IT systems and resources;
| | - | ------------------------------------------------------------

| |  | easily
integrate packaged applications and build customized applications;
| | - | -------------------------------------------------------------------------

| |  | significantly
decrease maintenance, human resource, and technology costs;
| | - | -------------------------------------------------------------------------

| |  | quickly
migrate to modern databases, platforms, applications, and programming languages;
| | - | ----------------------------------------------------------------------------------------

| |  | substantially
transform applications and databases in order to address regulatory and business changes;
and
| | - | -----------------------------------------------------------------------------------------------------------

| |  | directly
gain access to cutting edge technology and new business channels.
| | - | --------------------------------------------------------------------------

Our
comprehensive enterprise technologies span mainframe, midrange, and client/server
computing platforms. We have enhanced our expertise through the successful completion of
projects for many large organizations over the past 19 years, establishing our credibility
and achieving international recognition and presence. Based on our technology and that of
our affiliates, we develop and market software products, tools, and related methodologies.
We deliver our tools and methodologies together with training and support in order to
provide enterprises with comprehensive solutions, primarily for the modernization of
existing IT systems.

20

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In
1997, we introduced our C-MILL millennium conversion tool, which was developed based on
our generic modernization technology. In 1997 and 1998, we derived substantially all of
our revenues from millennium conversion projects. Since 2000, we have derived all of our
revenues from providing legacy modernization and porting solutions.

As
part of our growth strategy, we sought opportunities to increase our revenue base through
the acquisition of complementary products and services. This culminated in the acquisition
of a controlling interest in Liraz in November 2002, and the purchase of the remaining
outstanding interest in Liraz in March 2003. Lirazs business included the operations
of BluePhoenix Solutions B.V. and its international subsidiaries. Through our
subsidiaries, we develop and market AppBuilder, formerly developed and marketed by Liraz,
a software product used for the development of sophisticated and robust applications
needed by large enterprises. Following the acquisition, we have benefited from
Lirazs large install base that includes leading international banks and financial
institutions, whose information systems operate in various legacy environments.

We
believe that following the Liraz acquisition, utilizing our combined broad technology
offering and our worldwide marketing capabilities, we became a leading global player in
the enterprise IT modernization market. With twelve offices in ten countries, six full
service delivery centers, and local representatives, we provide our tools and services
worldwide.

Market Background

Companies
initiate IT modernization projects for a wide range of reasons, such as:

| |  | maintaining
a competitive edge in the market;
| | - | ---------------------------------------------

| |  | addressing
changing business needs;
| | - | -----------------------------------

| |  | complying
with new regulations;
| | - | -------------------------------

| |  | reducing
maintenance, human resources, and technology costs; or
| | - | ---------------------------------------------------------------

| |  | gaining
access to cutting edge technology and new business channels.
| | - | --------------------------------------------------------------------

Among the
various alternatives to modernization, such as renewing legacy systems, buying packaged
software, or rebuilding entire applications, enterprise IT modernization, or EIM,
has proven to be the most efficient and viable way for companies to protect their existing
investments. We provide a range of solutions designed to efficiently address the challenge
of retaining the business knowledge built into the application code while updating the
system to reflect new requirements.

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The
EIM market is divided into the following categories:

Enterprise
IT Understanding  These solutions enable companies to make informed strategic
decisions regarding the future of their IT systems by automatically capturing multiple
levels of operational and development information into a consolidated metadata warehouse.
Our tools facilitate global assessments and impact analyses of application assets, thus
helping reduce costs, streamline working processes, and increase efficiency.

Enterprise
IT Migration  These solutions enable companies to consolidate and eliminate a wide
range of legacy hardware and software through automated migration of applications,
databases, platforms, programming languages, and data. These tools help to reduce costs
and resources, and minimize reliance on proprietary technology, sunset products, and
dwindling skill sets. The SOA-ready solution is provided as a post-migration service,
allowing customers to extend their development environment by providing access to
mainframe systems through Web services protocols, making legacy systems appear as modern
systems.

Enterprise
IT Remediation  These solutions enable companies to extend the life of their
existing IT systems by quickly adapting to new regulatory changes and business
requirements. These automated tools can be easily customized to fit any IT environment and
corporate need, including data field adjustment, IT standardization, and system
consolidation.

Enterprise
IT Redevelopment  These solutions enable companies to mine existing applications
by extracting business rules, data flows, and data models, and then reusing the proven
code base to create more flexible Java/Web-based applications. Our tools help reduce
maintenance costs and resources and application development time-to-market.

Enterprise IT
Understanding

In
the current lean budgetary environment, companies that want to extend the return on
investment of their existing systems need to modernize their legacy systems. Since
modernization projects are intricate and complex, the essential first step is a thorough
review of existing IT assets.

Our
understanding solutions provide automated, detailed mapping of system-wide IT
activity and the interconnections between all software components. This detailed road map
serves as the basis for optimizing the reuse of existing IT systems, tailoring the
modernization plan for the companys unique IT environment and corporate
requirements, and reducing future ongoing maintenance costs.

Modernization
initiatives that need to be based on an in-depth examination of actual system elements
include:

| |  | building
and rewriting enterprise-scale application components;
| | - | ---------------------------------------------------------------

| |  | implementing
new technologies such as Web-enablement;
| | - | -----------------------------------------------------

| |  | integrating
purchased and newly written applications;
| | - | -----------------------------------------------------

| |  | consolidating
servers and applications;
| | - | ---------------------------------------

| |  | migrating
to more modern platforms, databases and languages;
| | - | ------------------------------------------------------------

| |  | transforming
current applications to adapt to changing business standards; and
| | - | ------------------------------------------------------------------------------

| |  | protecting
against the loss of critical personnel and corporate knowledge base.
| | - | -------------------------------------------------------------------------------

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|Our
integrated set of enterprise IT understanding solutions are designed to assist
companies in achieving these goals by accurately mapping raw IT operational and
development data, down to the program code level, into a consolidated enterprise-wide
warehouse. The gathered information enables companies to keep track of system inventories,
resources, and interrelationships and to intelligently mine systems and application
metadata.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

This
enterprise-wide view can then be used for a variety of strategic purposes, including:

| |  | performing
impact, cost, and trend analyses as well as ongoing tracking of IT resources,
inventories, components, their usage and their interrelationships;
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | running
business-logic analyses for business process identification, evaluation, extraction,
transition and                   enhancement;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------

| |  | achieving
significant cost reductions through the elimination of unused products, unnecessary
software upgrades, inefficient storage allocations, and wasteful CPU usage; and
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | providing
more efficient application development by reusing systems and leveraging existing
business rules.
| | - | -----------------------------------------------------------------------------------------------------------

|BluePhoenix
IT Discovery  This solution provides fast and convenient access to
application inventory, dependency, and operational information. This tool performs the
complete audit necessary to enable companies to define and analyze all application assets
in order to make informed decisions about ongoing modernization activities.
IT Discovery provides the ability to analyze on a refreshable basis numerous
technology environments, and from them extract and report on the interrelationships among
the components that make up these environments. In this manner, it provides an
organization the ability to discover information about its current systems, thereby
insuring that ongoing decisions are made based on an accurate audit of the current
environment.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|BluePhoenix
LogicMiner  This recovery solution mines COBOL and extracts business rules from
the legacy code, thus providing IT departments with the ability to begin a modernization
process based on techniques that preserve the functionality of legacy code. This tool
retains past investments in software assets by producing reusable code objects or
descriptive data that can later be used for improving the quality of the legacy code,
rewriting the legacy application, or building a full modernization plan. LogicMiner
increases a systems manageability, while eliminating rules that no longer apply to
current business procedures.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Enterprise
IT Migration

|Our
comprehensive, integrated set of enterprise IT migration solutions enable companies
to standardize and consolidate their IT systems by automatically converting and
redeploying applications, databases, platforms, programming languages and data that are
implemented on outdated computing platforms.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

23

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|Buying
a packaged application or rebuilding one can often be an expensive and risky proposition.
Therefore, companies often look towards migrating their existing applications. This option
is much more cost-effective and time-efficient as it leverages their existing investments
in custom applications. Additionally, our migration solutions enable companies to operate
their IT systems independently, without relying on previous technology support providers.
Thus, the migration process provides significant cost savings on development, maintenance,
and human resources.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Our
migration solutions provide numerous advantages, including:

| |  | significantly
decreasing project costs, risk of errors and time;
| | - | ----------------------------------------------------------------

| |  | preserving
corporate business knowledge;
| | - | ----------------------------------------

| |  | substantially
reducing dependency on scarce skill sets;
| | - | -------------------------------------------------------

| |  | solving
problematic maintenance issues;
| | - | ---------------------------------------

| |  | enabling
end-to-end project control and management;
| | - | ---------------------------------------------------

| |  | directly
supplying a full audit trail and documentation of all changes;
| | - | -----------------------------------------------------------------------

| |  | minimizing
system freeze time with a unique "refresh" feature; and
| | - | ------------------------------------------------------------------

| |  | comprehensively
working with most mainframe and non-mainframe platforms.
| | - | ------------------------------------------------------------------------

The
enterprise IT migration suite includes the following solutions:

|BluePhoenix
DBMSMigrator An automated migration tool that converts applications from
nonrelational databases, such as IDMS, ADABAS, IMS, and VSAM, to relational databases,
such as DB2, Oracle, and SQL Server. The tool performs automated conversions that provide
companies with fully functional compliance for source and target applications and minimal
application, functional, and logical program flow changes. DBMSMigrator leaves no
residuals, emulation software, or translation procedures and allows system support to
continue uninterrupted during the migration project. As a result of the conversion
process, the migrated application operates more efficiently, is easier to maintain, and
contains complete documentation of the customers knowledge base and guidelines.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|BluePhoenix
PlatformMigrator An automated migration tool that convertsa range of
platforms, including VSE, MVS, and Bull GCOS, and can becustomized to fit the
unique IT configuration and business rules of each customer site. The tool converts
platforms to a pure, native installation so that programs are not required to run under
emulation or through translation techniques. PlatformMigrator solutions assist
companies with maintaining service levels, setting and upgrading standards, implementing
the new IT environment, training IT users, implementing new facilities like a security
system or a batch scheduler, and testing for functional equivalence.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

BluePhoenix
Rehosting Organizations implement mainframe rehosting in order to reduce the
ongoing costs of existing legacy CICS and batch applications. Rehosting leverages the
strength and investment of older COBOL applications while taking advantage of new,
cost-efficient hardware and open operating system environments such as Linux, Unix,
Windows, J2EE, and .NET.

Using
our various automated migration tools, and cooperating with our partners, we offer COBOL
migration and mainframe rehosting solutions. We formed the following alliances for
providing these solutions:

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| |  | a
cooperation with Micro Focus for implementing their "Lift and Shift" strategy. Micro
Focus is a member of                     the Migration and Transformation Consortium
(MTC) for COBOL solutions;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | an
alliance with Sun Microsystems for assisting companies to rehost mainframe applications
on more                     cost-efficient, open platforms; and
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | a
collaboration with Fujitsu for assisting companies to migrate COBOL/CICS applications
into Fujitsu NetCOBOL and the Fujitsu NeoKicks and NeoBatch environments for handing CICS
and batch/JCL.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|BluePhoenix
LanguageMigrator An automated migration tool for converting COBOL and 4GLs
(fourth generation languages) such as ADSO, Natural, Mantis, and PowerBuilder to COBOL and
Java/J2EE. This reliable, time-efficient, and comprehensive solution enables site-wide
installation, simultaneous testing, and implementation of batch programs. In addition,
LanguageMigrator identifies the compatibility of the code, converts it to the new
standards required by customers, and analyzes converted programs to identify potential
problems. For more information about future developments of this tool, see Research
and Development.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|BluePhoenix
DataMigrator A Windows-based tool for migrating data between various data system
environments. Coupled with a step-by-step proven methodology, the tool provides a fully
structured but still versatile automated data migration process. DataMigrator enables full
control of source and target data definitions resulting in consistent, accurate, highest
quality target data with no data loss, and efficient utilization of available resources.
In addition, it provides support for partial or incremental migration and for multiple
runtime environments.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

BluePhoenix
WS4Legacy  This post-migration, SOA-ready enablement service extends the useful
life of valuable legacy applications that run on historic mainframe platforms by allowing
them to be easily reused in a modern Web-centric environment. The WS4Legacy comprehensive
solution provides Web services and Web clients for legacy applications. This unique set of
tools enables the exposure of a legacy application to more modern applications written in
Java or .NET by providing a Web service interface for the legacy system. Our WS4Legacy
tools also provide a Web-based display for legacy (3270) applications. These tools are
noninvasive and allow the legacy application to remain untouched.

Enterprise
IT Remediation

|Our
integrated set of enterprise IT remediation solutions enable companies to extend
the life of their existing IT systems when facing ongoing regulatory changes and new
business requirements. Our remediation solutions address a variety of corporate
needs and include:
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|BluePhoenix
FieldEnabler New business decisions or regulatory requirements often require
companies to make changes that impact a wide range of system components. These include
field adjustments that involve changes in the type, length, and structure of a database or
program field, such as expanding a dealer code. FieldEnabler is a rule-based tool
that enables a step-by-step, comprehensive process for making these kinds of modifications
across an enterprise in a reliable and time-efficient manner.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

25

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BluePhoenix
StandardsEnabler A highly automated solution for reliably facilitating system
consolidation into a single set of naming standards. Since all resources being converted
must be changed in parallel, the large task of manually standardizing the naming of system
components is not practical. Our tool provides an automated solution addressing this
problem.

BluePhoenix
COBOL/LE-Enabler A highly automated solution that facilitates the migration of
COBOL code from non-LE compliant environments to LE compliant environments.

BluePhoenix
EuroEnabler A highly automated solution that enables the transformation of
applications to be euro compliant. EuroEnabler fully preserves system and data
integrity and helps to maintain existing levels of system application development and
maintenance throughout the process.

Enterprise IT
Redevelopment

Enterprise
IT environments are complex, and can prevent companies from quickly and easily adapting to
new business needs and requirements. The more companies can organize and understand their
applications, the faster they can adapt to inevitable changes. While organizations are
mostly satisfied with the existing business functionality of their applications, they
usually want to improve their business processes and leverage technologies such as
Web-enabled and service-oriented architectures. Additionally, they are eager to find a way
to decrease their maintenance costs, which typically consume 70%80% of total IT
spending.

|Our
enterprise IT redevelopmentsuite enables companies to efficiently mine, reuse, and
rewrite their existing applications, thus incrementally redeveloping their legacy systems,
extending them into new technologies, and saving on development and programmer costs.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|BluePhoenix
AppBuilder  Our primary redevelopment legacy environment has been used for
managing, maintaining, and reusing the complicated applications needed by large
businesses. It provides the infrastructure for enterprises worldwide, across several
industries, with applications running millions of transactions daily on legacy systems.
Enterprises using AppBuilder can build, deploy, and maintain large-scale
custom-built business applications for years without being dependent on any particular
technology until they cease using their legacy infrastructure. AppBuilder acts like
a virtual application warehouse, keeping the underlying structure of the system in an
organized framework such that developers can easily understand it. This allows companies
to reuse critical business components, realizing a long-term return on investment for both
new and existing applications.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|BluePhoenix
ReBuilder Based on AppBuilder, ReBuilder transforms legacy COBOL programs into
service oriented applications deployed on the latest platforms. The resulting application
conforms to industry standards and is written in clean, maintainable source code. This
conformance to standard architectures, such as full object-orientation and Web services,
is a key differentiator in the ReBuilder approach when compared to more common migrations.
Instead of using the common approach where each line of COBOL source code is translated to
one or more statements in the target language (known as 1-1 approach), ReBuilder uses a
model based approach. ReBuilder develops a platform independent model from platform
specific models of legacy COBOL applications identified by BluePhoenix LogicMiner. This
platform independent model may then be extended to meet new business requirements. Finally
the application is generated to J2EE, .NET, or COBOL.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

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|Visual
MainWin® for the Unix and Linux platforms (formerly MainWin) Visual
MainWin® for the Unix and Linux platforms is an application-porting platform that
enables independent software vendors to develop applications in Visual C++ and deploy them
natively on Unix and Linux without the investment that is usually associated with
designing and developing a new source code base for Unix platforms.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|In
1994, Mainsoft entered into a licensing agreement with Microsoft, pursuant to which
Microsoft granted Mainsoft access to specified Microsoft source code, including new
versions, service packs, and upgrade releases for Windows. Microsoft also granted Mainsoft
distribution rights to the Windows object code licensed as a component in Visual MainWin
for Unix. Visual MainWin for Unix is already a mature product and Mainsoft
primarily focuses on supporting and maintaining its existing Visual MainWin for
Unix customers. We believe that our growth engine is the Visual MainWin for J2EE
product described below.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Visual
MainWin® for the J2EE platform During 2005, Mainsoft continued to invest in
the research and development, sales and marketing of its new Visual MainWin® for
J2EEproduct. In the first quarter of 2006, Mainsoft signed a teaming agreement with
IBM, according to which IBM will use Mainsoft product as part of its Linux and IBM
WebSphere software offered by IBM to IT enterprises and software vendors having
significant investments in the Microsoft development platform.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Investments and
Acquisitions

In
order to enhance our solutions and services portfolio, we have been pursuing a strategy of
adding new technologies to our suite of automated modernization tools. We implement this
strategy via internal development of new software tools and through acquisitions and
investments. Accordingly, we devote significant resources to the development and marketing
of new software modernization tools, and invest in businesses that develop software tools
that are complementary to our existing portfolio. The broad portfolio that we established,
among others, through these acquisitions, contributes to our ability to penetrate new
markets and to offer a complete set of solutions addressing the broad array of changing
demands of our customers. We integrate the acquired businesses into our business and
assimilate many of their functions, including, marketing, sales, finance and
administration into our existing infrastructure.

Following
is a description of our investments and acquisitions, which form a part of our business as
described above:

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Liraz. In November 2002, we purchased through a share exchange
          transaction, approximately 86% of the outstanding share capital of Liraz, an
          international software and services company, developing and marketing the
          AppBuilder, then publicly traded on the TASE. As part of the share exchange
          transaction, we issued to Lirazs selling shareholders, including Formula,
          3,478,624 of our ordinary shares, constituting an aggregate of 26% of our
          outstanding share capital. In two public tender offers that we published in
          December 2002 and March 2003, we purchased additional shares of Liraz
          representing 9% of the outstanding share capital of Liraz. In March 2003,
          pursuant to the provisions of the Israeli Companies Law, we purchased the
          remaining outstanding share capital of Liraz. The total aggregate amount of
          those cash purchases was $2.7 million. Following these transactions, we
          currently hold the entire outstanding share capital of Liraz. During 2003 and
          2004, we assimilated and integrated Lirazs infrastructure, management,
          personnel and sales and marketing activities within our business.

For
more information about the AppBuilder, see Enterprise IT
Redevelopment  BluePhoenix AppBuilder.

Mainsoft.
Since
1999, we purchased, in a series of transactions, 57.5% of the outstanding           share
capital of Mainsoft, for aggregate consideration of approximately $17.2
          million. These holdings include the exercise of a warrant in May 2003, pursuant
          to which we purchased 630,000 shares of Mainsoft for an aggregate of $378,000.
          We believe that our controlling interest in Mainsoft, the developer and
marketer           of the Visual MainWin® products, including Visual MainWin® for
J2EE,           enables us to address customer needs across a wide range of computing
platforms,           from mainframe through midrange and workstations. We also believe
that holding a           controlling interest in Mainsoft positions us as a specialized
cross-platform           software solutions provider. For more information about Mainsofts
          products, see Enterprise IT Redevelopment  Visual MainWin® for
the           Unix and Linux platforms; Visual MainWin® for J2EE Platform.

BluePhoenix
Solutions Srl. (previously known as AlphaTech (2000) Srl.). In December
2002, we purchased from Intercomp, our affiliate, a 65% controlling interest in AlphaTech
(2000) Srl. for aggregate consideration of $100,000. In February 2005, we entered into an
agreement with the other shareholder of AlphaTech to purchase for $250,000 its entire
holdings in AlphaTech, which as of such date was equal to 35% of AlphaTechs
outstanding share capital. In 2005, AlphaTech changed its name to BluePhoenix Solutions
Srl. BluePhoenix Solutions Srl., a company incorporated in Romania, serves as our offshore
delivery center in Romania.

CePost. In January 2004, we purchased the entire outstanding share
          capital of CePost Ltd., an Israeli company that develops and markets software
          solutions for electronic document mining, management and presentment. Pursuant
          to the purchase agreement, we paid to the shareholders of CePost $172,500 and
          issued to them 31,496 BluePhoenixs ordinary shares. In addition, we
          undertook to pay to the sellers royalties from CePosts revenues in an
          amount of up to $1.5 million. At our option, we may pay the royalties in
          BluePhoenixs ordinary shares. In accordance with the purchase agreement,
          we paid to the sellers in 2005 and 2006 advances in an aggregate amount of
          $45,000 on account of the royalties.

Intercomp.          In
1998, we invested in Intercomp Ltd., which has developed a set of automated
          analysis and reengineering tools for legacy COBOL applications. During 2002 and
          2003, Intercomp focused its efforts on the development of software tools that
          comprise a part of BluePhoenix LogicMiner. For more information about
          LogicMiner, see Research and Development  Enterprise IT
          Understanding  BluePhoenix LogicMiner.

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In
the fourth quarter of 2003, we exercised an option to purchase from Intercomp its tool
known as AnalyzeIT for an aggregate of $1.9 million. In addition, we undertook to pay to
Intercomp royalties of 25% of the revenues generated from the purchased technology.
AnalyzeIT provides an analysis of a legacy application and creates a repository and
inventory of the applications components and the relationships between them,
presented graphically and in reports. In connection with the purchase of Intercomps
technology, we assumed the rights and obligations of Intercomp under a distribution
agreement described below. The consideration for the acquired technology was offset
against the outstanding loan balance owed to us by Intercomp, as described below.

During
1998 through 2003, we lent to Intercomp an aggregate of $3.7 million. As of December 31,
2005, after the offset of $1.9 million for the purchased technology, the outstanding
balance of the loans was approximately $2.0 million. The loans are required to be repaid
by Intercomp at the end of a 5-year period commencing on February 19, 2002 or earlier (i)
in the event of liquidation or acquisition of Intercomp by a third party; or (ii) if the
current ratio of Intercomp is equal or greater than 1.25. The loans bear interest at a
rate of LIBOR +1% per annum. The principal of the loans plus interest accrued are
convertible into preferred shares of Intercomp at a conversion price of $162.70 per share.
In addition, in the first quarter of 2006, FIMI has completed exercising a put option to
sell to us convertible promissory notes issued by Intercomp, in an aggregate principal
amount of $3.5 million. For more information about this transaction, see Item 5.B.
Liquidity and Capital Resources  Contractual Commitments and Guarantees.

In
March 2004, we exercised an option granted to us effective as of January 2004, to purchase
from Eran Tirer all of its holdings in Intercomp, constituting 18.5% of the outstanding
share capital of Intercomp. In consideration, we issued to Mr. Tirer warrants to purchase
5,000 BluePhoenix ordinary shares at an exercise price of $20 per share, which expired on
October 25, 2005 and were not exercised. As part of the transaction with Mr. Tirer,
certain shareholders of Intercomp, holding 2.1% of Intercomps outstanding share
capital, transferred to us their holdings in Intercomp. In addition, the remaining
shareholders of Intercomp comprised of several funds acting through their general partner,
Infinity, converted certain outstanding loans owed to them by Intercomp into 7,236 shares
of Intercomp at a price of $162.70 per share. Following these transactions, our holdings
in Intercomp increased from 49% to approximately 62%. Since the end of the first quarter
of 2004, we consolidated the results of operations of Intercomp.

Concurrently
with the grant by Mr. Tirer of the option to purchase from him his holdings in Intercomp,
Intercomp granted nonexclusive rights to a distributor partially owned by Mr. Tirer, to
further develop and distribute Intercomps products.

In
April 2004, Infinity granted us a call option to purchase its entire holdings in
Intercomp, exercisable until April 1, 2006. If we do not exercise such option, Infinity
will have a put option to cause us to purchase Infinitys entire holdings in
Intercomp, exercisable during a period of six months commencing in April 2006. If either
of the options is exercised, we shall be obligated to issue to Infinity, as consideration
for Intercomps shares, 100,000 BluePhoenix ordinary shares and an additional amount
of shares to be calculated based on revenues generated from the sale of licenses to use
Intercomps products during a 3-year period commencing on April 1, 2003, as follows:

29

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| |  | For
the first $3 million of revenues, the number of additional shares shall be equal to
10,000 shares for each $1 million of revenues.
| | - | --------------------------------------------------------------------------------------------------------------------------------------

| |  | If
revenues exceed $3,000,000 but are less than or equal to $15,000,000, then the number of
additional shares shall be equal to 30,000 plus 20,000 shares for each $1 million of
revenues exceeding $3 million.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | If revenues exceed $15,000,000, then the number of additional shares shall be equal to
270,000 plus 10,000 shares for each $1 million of revenues exceeding $15 million.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------

We
undertook, upon Infinitys request, to use our best efforts to effect registration of
the shares, within 8 months from April 1, 2006 or within 90 days of such date, if we filed
our annual report on Form 20-F during such 90-day period, whichever is earlier. We may, at
our option, pay to Infinity the cash equivalent of such shares, which will be calculated
according to the average closing price of BluePhoenixs shares during the 20 trading
days prior to the exercise of any of the options.

IntraComp. IntraComp Group Inc. provides migration and conversion services           for
large-scale systems and back-end integration services. In 2000, we acquired           a
53% controlling interest in IntraComp for aggregate consideration of
          approximately $3.4 million. During the second quarter of 2003, we purchased
from           the other shareholders of IntraComp the remaining outstanding share
capital of           IntraComp for consideration to be calculated based on IntraComps
          cumulative earnings before interest and taxes during the three-year period
          commencing on January 1, 2003. Based on a final report of IntraComps
          earnings in the three-year period, we did not pay any consideration for the
          purchase of the remaining share capital. Following the purchase of the entire
          interest in IntraComp, we completed the integration of IntraComps
business           into ours.For more information about IntraComps
solutions, see           Enterprise IT Migration  BluePhoenix PlatformMigrator.

I-Ter/Informatica
& Territorio S.p.A.In the second quarter of 2005, we entered into an
agreement to purchase the entire outstanding share capital of I-Ter. I-Ter is a developer
and marketer of software solutions for migration from DL1 to DB2, and from IMS/DC to CICS,
porting of applications from mainframe and Unix Sun Solaris. Pursuant to the purchase
agreement, we paid to the selling shareholders of I-Ter in the second quarter of 2005,
$1.4 million. Under the terms of the transaction, we agreed to pay the selling
shareholders an additional consideration of up to $720,000 calculated based on
I-Ters cumulative earnings before interest and taxes, referred to as EBIT. As
agreed, if the EBIT in any calendar year during the three-year period commencing on
January 1, 2005, is equal to or greater than $6,000, we will pay the selling shareholders
an additional $240,000 with respect to each such year. In addition, we agreed to pay to
the selling shareholders, at such date that is 15 business days following the date on
which the EBIT report for the year ended on December 31, 2007 is final, an additional
consideration equal to seven times of the yearly average EBIT in the three-year period
commencing on January 1, 2005, less the amounts already paid to the selling shareholders
for the purchased shares. In addition, in the event that the yearly average EBIT in the
three-year period commencing on January 1, 2005 is greater than $600,000, we shall pay the
selling shareholders an amount equal to nine times of the difference between the yearly
average EBIT in the three-year period commencing on January 1, 2005 and $600,000.

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MultiConn.In 1999, we acquired 51% of the outstanding share capital of           M.S.I.
MultiConn Solutions International (1995) Ltd., referred to as M.S.I.           MultiConn,
and in 2000, we increased our shareholdings in M.S.I. MultiConn to           60%.
Effective as of January 2004, the other shareholders of M.S.I. MultiConn
          transferred their entire holdings in M.S.I. MultiConn to us. Following this
          transaction, we assumed control over the daily management of M.S.I. MultiConn.
          We currently wholly own M.S.I. MultiConn and finance its activities.

In
2000, we established together with the other shareholders of M.S.I. MultiConn, a company
named MultiConn Technologies Ltd. and initially owned 19% of its share capital. MultiConn
Technologies develops and markets BluePhoenix WS4Legacy. In 2002, we increased our
holdings in MultiConn Technologies to 60%. Following a transaction entered into between us
and the other shareholders of MultiConn Technologies in 2004, the other shareholders of
MultiConn Technologies increased their holdings in MultiConn Technologies to 58.2% in the
aggregate, through the issuance of shares by MultiConn Technologies. As a result, we
currently hold approximately 40% of the outstanding share capital of MultiConn
Technologies. We have an option to increase our holdings in MultiConn Technologies to 60%
of its outstanding share capital for an exercise price of $50,000. As of March 24, 2006,
we lent to MultiConn Technologies an aggregate amount of $2.4 million. In 2004, we
included in our equity in affiliated companies 100% of the losses of MultiConn
Technologies. As of December 31, 2004, we consolidated MultiConn Technologies
balance sheet with ours. In 2003, we wrote down $350,000 of the balance of our investments
and loans to MultiConn Technologies, due to the impairment of the investment and since it
was probable that we would be unable to collect all amounts due. For more information
about BluePhoenix WS4Legacy, see Enterprise IT
Migration  BluePhoenix WS4Legacy.

Outlook.Effective as of January 2004, we acquired from an Israeli           company,
Outlook Systems Ltd., through our new wholly owned subsidiary, Outlook           & BluePhoenix
Ltd., Outlook Systems entire business activities in           Israel in the field
of software development services. Pursuant to the purchase           agreement, we hired
31 employees previously employed by Outlook Systems and           assumed all the
obligations in respect of the purchased activity. These           obligations include the
extension of a guarantee to a bank with respect to loans           in an aggregate amount
of $720,000 plus interest accrued, to be repaid by us by           February 15, 2007. In
the first quarter of 2006, we amended the terms of the           purchase agreement with
Outlook Systems. Pursuant to the amendment, in lieu of           (i) the consideration
payable to Outlook Systems under the purchase agreement;           and (ii) our
obligation to extend a guarantee on behalf of Outlook Systems, we           paid to
Outlook Systems an aggregate amount of approximately $1.3 million.           Accordingly,
the guarantees we extended to a bank with respects to Outlook           Systems loans was
cancelled. In addition, Outlook Systems received 138,591 of           BluePhoenix
ordinary shares. As part of the amendment, we undertook to pay           Outlook Systems
a consideration to be calculated based on Outlook &          BluePhoenix Ltd.s
annual earnings before interest and taxes, referred to           as EBIT, during the
three-year period commencing on July 1, 2005, as follows:

31

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| |  | For
an amount of up to $300,000 of the annual EBIT in each year within the three-year EBIT
period, we will pay Outlook Systems a consideration equal to 10% of the EBIT;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | For
an amount of annual EBIT in a fiscal year within the three-year EBIT period in excess of
$300,000, we will pay Outlook Systems additional consideration equal to 15% of the
excessive amount.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Zulu
Software Inc. In February 2005, we entered into an agreement to purchase up
to 20% of the outstanding share capital of Zulu Software, Inc., or Zulu, on a fully
diluted basis. Under the purchase agreement, the purchase price was divided into four
installments, each to be paid subject to fulfillment of a certain milestone. We paid the
first installment of $350,000 in February 2005 against the issuance to us of 8% of
Zulus outstanding share capital. We have not made additional payments because the
agreed upon milestones have not been met. In January 2006, we purchased from the other
shareholders of Zulu additional shares increasing our holdings to 72% of Zulus
outstanding share capital. The aggregate consideration we paid for this additional
purchase was $2.4 million. In addition, in February 2005, we entered into an alliance
agreement with Zulu for cooperation in marketing and selling Zulus and our software
tools and services. Zulu is a developer and marketer of software solutions for migration
from ADABAS/Natural to Java. For more information about Zulus software solutions,
see Enterprise IT Migration  BluePhoenix LanguageMigrator.

|Level
8. As of March 24, 2006, we hold several capital instruments, including
warrants and rights to receive warrants, exercisable into shares of Level 8 Systems Inc.
If we exercise these capital instruments in full, we will hold approximately 13 million
ordinary shares of Level 8. In 2003, we purchased 444,444 ordinary shares of Level 8 for
$200,000. During 2003 and in the first quarter of 2004, we sold substantially all of the
shares of Level 8 then held by us for $624,000. We provide to Bank HaPoalim a
guarantee to secure Level 8s loan from the bank, in an amount of approximately $2
million, as of March 24, 2006. The guarantee is extended from time to time and it is
currently in effect until November 2006. In consideration for the extension of the
guarantee, Level 8 issued to us 300,000 ordinary shares and we are entitled to be granted
an additional 6,342,000 ordinary shares of Level 8. In addition, we have been granted
warrants to purchase 3,600,000 ordinary shares of Level 8 at an exercise price of $0.02.
In the event that the guarantee is exercised, the bank is obligated to grant to us a
three-year loan in an amount of up to the amount of the guarantee.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|In
September 2004, we extended a loan to Level 8 of approximately $97,000 under a secured
promissory note. The note bears interest at an annual rate of 10%. In consideration, we
are entitled to receive warrants to purchase 1,986,468 ordinary shares of Level 8 at an
exercise price of $0.10 per share.
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Steps
Ventures.As of March 24, 2006, we hold 375,000 shares of Steps Ventures
Ltd. comprising 3.75% of the outstanding share capital of Steps Ventures. Steps Ventures
is an Israeli venture capital investment group focusing on Israeli startup companies in
the fields of software, telecommunications and semiconductors.

32

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Customers

We
provide our modernization solutions directly or through our strategic partners, such as
IBM, EDS, Cook Systems, TEMENOS, Matrix, and TACT. Additionally, from time to time, other
IT services companies license our technologies for use in modernization projects in
various markets. Our partners are usually system integrators who assist us in increasing
our penetration and exposure in the market. We provide solutions to our partners
customers in collaboration with the system integrators team. In most cases, the
partners provide related services to the customers. Our arrangements with our partners
vary. We may enter into distribution agreements with the partners under which we grant
license rights or to the partners customers, provide related services, or a
combination of both. Alternatively, we may enter into subcontractor relationships with our
strategic partners.

Approximately
30% of our agreements are based on fixed price contracts. These projects may bear some
risks and uncertainties as we price these contracts based on estimates of future costs,
duration of the project and the impact potential changes in the scope of the work. We also
enter into other types of contracts, including annual maintenance contracts, license
agreements and arrangements on a time and material basis. To date, shifts in revenues
generated from different types of agreements have not materially affected our results of
operations.

Our
customers include, among others:

|Financial Services | Insurance                                   | Other Industries
|------------------ | ------------------------------------------- | ----------------
|                   |                                             |                 
|                  | Banca Carige S.p.A.                         |                
|                  | Citibank                                    |                
|                  | Credit Suisse                               |                
|                  | Fidelity International 
Resource Management |                
|                  | Intensa Sistemi E Servizi                   |                
|                  | Rabobank Netherland BV                      |                
|                  | Rural Servicios      
Informaticos (Spain)  |                 
|                  | SDC Udvikling (Denmark)                     |                 
|                   |                                             |                 
|                   |                                             |                 
|                   |                                             |                 
|                   |                                             |                 
|                   |                                             |                 
|                   |                                             |                 
|                   |                                             |                 
|                   |                                             |                 
|                   |                                             |                 
|                   |                                             |                 
|                   |                                             |                 

33

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Each
of the customers mentioned above contributed at least $600,000 to our annual revenues for
a project performed within the previous two fiscal years.

SDC
Udvikling A/S, referred to as SDC Udvikling, an affiliated company of SDC, accounted for
17% and 15% of our revenues in 2005 and 2004.

The
following table summarizes the revenues from our tools and services by geographic regions
for the periods indicated:

|                            | Year ended December 31,
|--------------------------- | -----------------------
|
|
|
|
|United States               |                        
|Europe (other than Denmark) |                        
|Denmark                     |                        
|Israel                      |                        
|Other                       |                        
|                            |                        
|Total                       |                        

Research and Development

In
order to maintain our position as a market leader in the IT modernization market, we are
focusing our development efforts on further enhancements to current solutions, as well as
addressing newly emerging aspects of the modernization market. We are planning additional
software development activities to extend our modernization solutions by leveraging our
technological skills to create added value for our customers and to generate additional
business opportunities.

The
next generation of our solutions will be extended to address the entire modernization
process from legacy systems to modern platforms. We have started to develop our next
generation of products and tools, which will allow the fluent transformation of legacy
code to state-of-the-art platforms, such as J2EE and .NET. The new generation of solutions
is composed of products and tools in several EIM categories.

Enterprise IT
Understanding

BluePhoenix
IT Discovery  By further refining our existing understanding technology and
combining it with the additional technology licensed from Merrill Lynch, IT Discovery
will provide the basis for legacy understanding needed by the rest of our modernization
solutions.

Enterprise IT Automated
Migration

Fourth
Generation Language Migration  In the area of automated migration, we continue to
build on our 4GL migration solutions. Our assets in the migration area cover COOL:Gen,
Mantis, ADSO/IDMS, Natural, CSP, and PowerBuilder transformations. We continue to extend
the support target platform of these transformations to include J2EE and .NET platforms.

34

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Enterprise
IT SOA Ready Solution  A comprehensive solution that provides Web services or
clients for a legacy application. Our unique suite of tools enables a legacy application
to be exposed to more modern applications written in Java or .NET by providing a web
service interface for the legacy system. Our tools are also able to provide a web based
appearance/ connectivity/ interface legacy applications. Both the solutions are not
intrusive and allow the legacy application to remain untouched.

|BluePhoenix
LogicMiner A comprehensive solution for recovery that mines COBOL and extracts
business rules from the legacy code, thus providing IT departments with the ability to
begin a modernization process based on techniques that preserve the functionality of a
legacy code. This tool retains past investments in software assets by producing reusable
code objects or descriptive data that can later be used for improving the quality of the
legacy code, rewriting the legacy application, or building a full modernization plan.
LogicMiner increases a systems manageability, while eliminating rules that no
longer apply to current business procedures. We intend to incorporate technology owned by
MultiConn Technologies that performs automatic generation of Web and SOA service
interfaces for existing applications into LogicMiner to allow for easy Web services
enablement of legacy through either existing or new LogicMiner created interfaces.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|BluePhoenix
Refactoring Repository (Nebula  code name)  A repository that
supports the storage and management of the abstract models and code of applications that
make use of multiple development architectures such as legacy information engineering and
more modern object oriented and service oriented architectures.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|BluePhoenixReBuilder  Once legacy models and code are refactored, ReBuilder will
provide the ability to generate from the abstract platform independent model stored in the
Refactoring Repository to platform specific models such as J2EE and .NET. To
address this, we are extending robust generation technologies to generate platform
specifics for object orientation and SOA. This model driven modernization environment can
be used to gradually migrate applications rather than requiring an all at once
approach. In order to address refactoring, which involves changing from one application
model to another, we are adding the necessary tools to assist in the process of taking the
information from legacy applications architectures via LogicMiner to more
modern architectures such as object and SOA.
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Mainsofts
Visual MainWin® for the J2EE platform  Mainsofts Visual MainWin® for
the J2EE platform, launched in February 2004, is a cross-platform development solution
that bridges the .NET/J2EE divide, enabling Visual Basic .NET and C# developers to develop
J2EE Web applications and Web services using the Visual Studio .NET development
environment. In 2005, Mainsoft released versions 1.6 and 1.7 of Visual MainWin® for
the J2EE platform to support its go-to-market strategy. Version 1.6 launched in May 2005
supported Mainsoft developer marketing initiative delivering a free developer edition of
the product and launching the first Linux site for Visual Studio developers. Version 1.7
introduced in December 2005 supports the IBM partnership, including validation on all IBM
eServer product line and support for IBM WebSphere Express and WebSphere Application
Server 6.0. This product is based on the Mono project, an open source .NET implementation,
led by Novell and it is not dependant upon Microsoft source code.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

35

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|Mainsoft
also began marketing Visual MainWin for Unix 5.0.4 in November 2005 with support for more
Unix and Linux platforms and support for Visual Studio 2003.
|---------------------------------------------------------------------------------------------------------------------------------------------------------------

Costs and Grants

As
of December 31, 2005, we employed 140 employees in our software development departments.
Our net development expenditures were $8.0 million in 2005, $8.1 million in 2004 and $8.1
million in 2003. Certain of our new product development projects have been awarded
research grants, of which some that are repayable as royalties.

Chief Scientist Grants

Visual
MainWin® for J2EE Platform  Through December 31, 2005, our subsidiary,
Mainsoft, accrued an aggregate of approximately $1.4 million in grants from the Office of
the Chief Scientist, or the OCS, for the development of Visual MainWin® for J2EE.
Royalties of 3% are payable to the OCS on sales of Visual MainWin® for J2EE, up to
100% of the dollar-linked grant received in respect of the funded product. To date,
Mainsoft has paid the royalties to the OCS as required. Mainsoft has submitted to the OCS
an application for obtaining research and development grants for 2006, which is pending
approval.

|PowerText  As
of January 1, 2004, we received through our wholly owned subsidiary, an aggregate of
approximately $200,000 in grants from the OCS for the development of PowerText. PowerText
is a software solution for automated electronic document mining, management and
presentment. Royalties of 3% are payable to the OCS on all sales of PowerText up to 100%
of the dollar-linked grant received. To date, CePost has paid to the OCS the royalties as
required.
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|BluePhoenix
WS4Legacy  Through December 31, 2004, our subsidiary, MultiConn Technologies,
accrued an aggregate of approximately $580,000 in grants from the OCS, for the development
of BluePhoenix WS4Legacy. Royalties of 3% are payable to the OCS on sales of
BluePhoenix WS4Legacy up to 100% of the dollar-linked grant received in respect of
the funded product.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

The balance
of the contingent liability relating to the royalties payable by our subsidiaries to the
OCS, at December 31, 2005, amounted to approximately $2.2 million.

Other Grants

In
the first quarter of 2004, the Singapore-Israel Industrial Research and Development
Foundation agreed to provide one of our wholly owned subsidiaries together with a company
incorporated in Singapore, financing for the development of a Java report generator based
on legacy text file input. Accordingly, the foundation agreed to award our subsidiary up
to $100,000 payable according to an agreed upon schedule. As of March 24, 2006, we
received $30,000 of the grant. The grant is required to be repaid in installments based on
sales of the funded product up to the amount of the grant.

36

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Our
subsidiary, I-Ter, is entitled to funds to develop Easy4Plan product, from the Ministry of
Production in Italy. Easy4Plan is a workflow management tool designed for ISO9000
companies. Approximately 30% of the funds are a grant, and the balance is an 8-year loan
to be repaid by I-Ter. The loan bears a minimal annual interest. The development term ends
in July 2006. We anticipate that during 2005 and 2006 I-Ter will receive a total aggregate
amount of $600,000.

Intellectual Property

We
rely on a combination of trade secret, copyright, and trademark laws and nondisclosure
agreements, to protect our proprietary know-how. Our proprietary technology incorporates
processes, methods, algorithms, and software that we believe are not easily copied.
Despite these precautions, it may be possible for unauthorized third parties to copy
aspects of our products or to obtain and use information that we regard as proprietary.
However, we believe that with regard to most of our solutions, because of the rapid pace
of technological change in the industry, patent and copyright protection are less
significant to our competitive position than factors such as the knowledge, ability, and
experience of our personnel, new product development, and ongoing product maintenance and
support.

# Competition

The
modernization market in which we operate is highly competitive. The principal competitive
factors affecting the market for our modernization solutions include:

|product
functionality, performance, and reliability;
|----------------------------------------------------

| |  | technical
range of the offered solutions;
| | - | -----------------------------------------

| |  | integration
between the offered solutions;
| | - | ------------------------------------------

| |  | availability
of experienced personnel and its expertise;
| | - | --------------------------------------------------------

| |  | prices;
| | - | -------

| |  | ability
to respond in a timely manner to changing customer needs;
| | - | -----------------------------------------------------------------

| |  | ease
of use; and
| | - | ----------------

| |  | quality
of support.
| | - | -------------------

Competition
in the enterprise IT modernization field is, to a large extent, based upon the
functionality of the tools and personnel expertise. Vendors in this market address the
evolutionary modernization of legacy systems in different ways, and therefore do not
always compete directly with others in the market. Many small vendors address only a small
part of the market, whereas only a few offer a comprehensive and integrated solution set
that can provide answers for most of the modernization challenges that companies currently
face.

37

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Our
principal competitors consist of system integrators, offshore outsourcers, and tool
vendors, including leading software developers, who enable customers to replace or
modernize their legacy systems. Major system integrators in the market include IBM,
Accenture, Capgemini, and EDS. IBM has established legacy modernization as a strategic
pillar of its long-term application development strategy. IBM has a specific, dominant
advantage in the underlying application development infrastructure associated with many
legacy environments (predominantly IBM mainframes) and it has a large service capability.
We cooperate with some of these system integrators in providing specific solutions.
Although all of them provide solutions for the modernization of enterprise systems, each
player focuses on different niches. Major offshore outsourcers in the market include TCS
(Tata Consulting Services), WIPRO, Patni, and Infosys. In addition, we face competition
from niche companies operating in each of the four principal areas of the enterprise IT
modernization market:

| |  | Enterprise
IT Understanding;
| | - | ----------------------------

| |  | Enterprise
IT Migration;
| | - | ------------------------

| |  | Enterprise
IT Remediation; and
| | - | ------------------------------

| |  | Enterprise
IT Redevelopment.
| | - | ----------------------------

For
example, Micro Focus International markets its solutions to the COBOL market, Most
Software Technologies addresses the ADABAS/Natural arena, and other competitors focus on
collecting sufficient information about application portfolios to enable improved working
processes. Other solution developers provide legacy and distributed repository solutions
that are important for a variety of modernization processes.

|C. | Organizational
Structure
|-- | ------------------------

We
are part of the Formula group, a global IT solutions and services group headquartered in
Israel. The Formula group is principally engaged in providing software consulting
services, developing proprietary software products, and providing computer-based business
solutions. The Formula group delivers its solutions in over 50 countries worldwide to
clients with complex IT services needs, including a number of Fortune 1000
companies. We are a subsidiary of Formula Systems (1985) Ltd., which holds directly 58.0
of our ordinary shares and, through voting agreements with Dan Goldstein, a director of
our company and Formulas chief executive officer and chairman of the board of
directors, and Gad Goldstein, the chairman of our board and a director and president of
Formula, beneficially own 63.5 of our ordinary shares.

Following
is a list of our significant subsidiaries, their country of incorporation, and proportion
of our ownership interest in them, as of March 24, 2006:

|Name of Subsidiary        | Country of
Incorporation | Proportion of
Ownership Interest
|------------------------- | ------------------------ | --------------------------------
|
|
|
|
|BluePhoenix Solutions B.V |                          |                                 
|                          |                          |                                 
|Liraz Systems Ltd.        |                          |                                 
|                          |                          |                                 
|Mainsoft Corporation      |                          |                                 

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|D. | Property,
Plants and Equipment
|-- | ------------------------------

We,
together with our subsidiaries and affiliates, currently occupy approximately 8,000 square
meters of office space. The aggregate annual rent we paid for these facilities in 2005 was
$1.5 million. The following table presents certain information about our facilities and
the terms of lease of these facilities.

|Country and State   | City                         | Sq.
Meters | Expiration     | Annual anticipated
rental fees in 2006
in thousands US$
|------------------- | ---------------------------- | ---------- | -------------- | -------------------------------------------------------
|Israel              | Herzlia                      | 1,830      | December 2006  | 420                                                    
|Israel              | Holon                        | 250        | February 2007  | 30                                                     
|Israel              | Lod                          | 165        | June 2006      | 140                                                    
|USA, North Carolina | Cary                         | 880        | April 2009     | 200                                                    
|USA, California     | San Jose                     | 350        | May 2006       | 30                                                     
|USA, Indiana        | South Bend                   | 410        | February 2007  | 80                                                     
|Denmark             | Ballerup                     | 1,500      | November 2008  | 140                                                    
|Germany             | Frankfurt                    | 270        | November 2006  | 70                                                     
|Romania             | Bucharest                    | 950        | November 2007  | 150                                                    
|United Kingdom      | Uxbridge                     | 40         | August 2006    | 90                                                     
|Cyprus              | Nicosia                      | 800        | June 2009      | 120                                                    
|Italy               | San Felice, Segrate  Milano | 150        | October 2010   | 20                                                     
|Italy               | Riccione                     | 330        | December 2010  | 40                                                     
|Italy               | Milano                       | 110        | December 2006  | 15                                                     
|Italy               | Roma                         | 120        | September 2011 | 30                                                     
|Total               |                              | 8,155      |                | 1,555                                                  

39

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If,
in the future, we determine that we need additional space to accommodate our growth, we
believe that we will be able to obtain this additional space without difficulty and at
commercially reasonable prices. We do not own any real property.

|ITEM 4A. | UNRESOLVED
STAFF COMMENTS
|-------- | -------------------------

None.

|ITEM 5. | OPERATING
AND FINANCIAL REVIEW AND PROSPECTS
|------- | --------------------------------------------

# Background

We
develop and market unique enterprise IT modernization solutions that enable companies to
automate the process of modernizing and upgrading their mainframe and distributed IT
infrastructure and to effectively compete in todays environment. The combination of
our comprehensive set of products and tools with our expert services methodology provides
an efficient and cost-effective process for extending the return on investment of existing
enterprise IT assets. Our solutions, which include technology for Understanding,
Migration, Remediation, and Redevelopment, allow companies to fully leverage
their current systems and applications, speed up and reduce the cost of the renewal
process, and effectively update their systems in order to adapt to new business demands.

Our
quarterly and annual results of operations have fluctuated significantly in the past and
we expect them to continue to fluctuate significantly in the future, as a result of
numerous factors, including the changes in the suite of modernization tools we have been
offering to our customers, the impact of acquisitions and dispositions of companies, the
limited experience we have had in the markets for these newly introduced tools, and the
difficulties we have encountered in introducing our tools to their respective markets.
Therefore, we believe that period-to-period comparisons of our financial results are not
necessarily meaningful and you should not rely on them as an indication for future
performance.

The
following discussion of our critical accounting policies and our financial condition and
operating results should be read in conjunction with our consolidated financial statements
and related notes, prepared in accordance with U.S. GAAP for the years ended December 31,
2005, 2004 and 2003, and with any other selected financial data included elsewhere in this
report.

40

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Overview

General

In
recent years, we have been affected by the global economic changes, in particular trends
in capital spending in the information technology sector. During 2001 through 2003, the
overall business slowdown in the North American and European markets influenced the
purchasing patterns of leading software developers who delayed their planned orders and
caused developers to reduce the amount of their planned commitment. These changes in
purchasing patterns in the IT industry directly affected our operating results. Our
revenues decreased from $49.2 million in 2000 to $38.4 million in 2001 and to $36.7
million in 2002. Since 2003, as a result of a slight recovery of the market, and the
impact of a strategic acquisition we completed, this trend changed, and our revenues
increased from $54.3 million in 2003 to $57.2 million and $58.9 million in 2004 and 2005,
respectively. As part of this change, our average backlog has increased from approximately
$25 million at the end of 2003 and 2004 to $50 million at the end of 2005. This increase
improves managements ability to engage in near-term planning. We typically fill
current backlog within one year.

In
providing our solutions, we work closely with our customers or system integrators, and can
therefore be impacted by holiday seasons of the customers and system integrators. As a
result, we may sometimes experience a decline in our third quarter revenues due to the
summer holiday season in Europe and Israel.

In
order to enhance our solutions and services portfolio, we have been pursuing a strategy of
adding new technologies to our suite of automated modernization tools. We implement this
strategy via internal development of new software tools and through acquisitions and
investments. Accordingly, we devote significant resources to the development and marketing
of new software modernization tools. In addition, we invest in businesses that develop
software tools that are complementary to our existing portfolio and have a skilled and
specialized workforce.

Liraz Acquisition

In
November 2002, we completed the acquisition of a majority of the outstanding share capital
of Liraz. In March 2003, we completed the acquisition of all the remaining outstanding
share capital of Liraz. Lirazs development environment, AppBuilder, acts as a
virtual application warehouse for large legacy mainframe installations. Most of
BluePhoenixs tools are based on generic technologies that were initially developed
to be used in the mainframe environment. By combining with Liraz, we increased sales of
our solutions by leveraging Lirazs well-developed marketing infrastructure and
expertise in the mainframe environment. In addition, the combination of our respective
technical personnel has enhanced our product development capabilities. We currently offer
a broad suite of enhanced enterprise IT modernization solutions, from legacy reuse to
platform rehosting, which we believe assists us in maintaining our position as a market
leader in the IT modernization market. Since the beginning of the integration process, our
management analyzes the combined business as one business unit.

41

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Visual MainWin

Our
revenues relating to the Visual MainWin product depend on the availability of
Windows source code, which is provided by Microsoft under its agreement with our
subsidiary, Mainsoft. We believe that the Windows source code leak in February 2004
has not interfered with our customer relationships. In order to diversify Mainsofts
product offering, we have been developing an innovative product that converts applications
developed on .NET to J2EE platform, without the need to rely on Microsofts source
code. While the recently introduced product has gained favorable interest in the
technological community, its sales grow slower than initially expected.

Challenges and
Opportunities

Our
principal opportunity is to enhance our revenues by leveraging the marketing resources and
skilled specialized workforce to market the suite of tools and solutions that we offer. In
addition, we have identified a market demand for complementary application development
services. Following the delivery of the converted code to the customer, a need to maintain
the new code arises. We intend to leverage our knowledge of our customers converted
applications, in order to assist them to further develop and integrate them in the mixed
information systems environment they maintain. Accordingly, we anticipate an increase in
revenues generated from our customers, by offering them post-conversion
application maintenance and development services.

The
principal challenge we face is to accomplish our growth objectives while also enhancing
profitability. In order to expand our revenue base, we will continue to invest in our
sales and marketing operations. Since our margins are dependent on the degree of
automation of our tools, we plan to continue devoting substantial resources to research
and development both internally and through acquisitions. There is no assurance that these
investments will lead to revenue growth. If they do not lead to such growth, our
profitability will be adversely affected. For example, we expended significant resources
to develop, and in 2004, we introduced, a new porting tool, Visual MainWin for J2EE,
through our subsidiary, Mainsoft. We consider this tools cross platform bridging
capabilities a technological breakthrough. However, we cannot assure you that this new
tool will gain market acceptance to the extent anticipated, and generate the expected
growth of revenues.

Since
2003, we have been enhancing since 2003 our offshore delivery centers in Romania and
Cyprus, where our operational costs are lower. These offshore centers allow us to reduce
the prices we charge our customers for our solutions and simultaneously improve our
operating profit. As the degree of automation of our tools increases, the need for expert
services decreases, and as a result, our direct expenses decrease. In addition, the
improved tools enable us to implement our distributed project methodology, and
simultaneously use our delivery centers that perform the actual modernization project with
our tools.

Consolidation of the
Results of Operations of Our Subsidiaries

Following
is information regarding the consolidation of the results of operations of certain of our
subsidiaries, for the periods indicated. We began to consolidate the results of operations
of each of these subsidiaries when we acquired control in them.

42

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|Name of Subsidiary                                       | Beginning Consolidation
|-------------------------------------------------------- | -----------------------
|
|
|
|
|SCH - Software Conversion House Ltd.                     | Second quarter of 1998 
|Mainsoft Corporation                                     | Fourth quarter of 1999 
|M.S.I. MultiConn Solutions International (1995) Ltd. (1) | Third quarter of 1999  
|IntraComp Group Inc.                                     | Second quarter of 2000 
|Liraz Systems Ltd.                                       | Fourth quarter of 2002 
|Advanced Systems Europe B.V                              | Fourth quarter of 2002 
|BluePhoenix Solutions B.V                                | Fourth quarter of 2002 
|Liacom Systems Ltd.                                      | Fourth quarter of 2002 
|Alexandria Migration Technologies Ltd.                   | First quarter of 2003  
|CePost Ltd.                                              | First quarter of 2004  
|Outlook & BluePhoenix Ltd.                               | First quarter of 2004  
|Intercomp Ltd.                                           | Second quarter of 2004 
|MultiConn Technologies Ltd.                              | First quarter of 2005  
|I-Ter/Informatica & Territorio S.p.A                     | Second quarter of 2005 
|Zulu Software Inc.                                       | First quarter of 2006  

---

(1)
          We did not consolidate the results of operations of M.S.I. MultiConn in 2003,
          since the other shareholders undertook the daily management and control.
          Following the acquisition of the remaining shareholdings of M.S.I. MultiConn
          from the other shareholders, effective as of the first quarter of 2004, M.S.I.
          MultiConns results are consolidated within ours.

Critical Accounting
Policies

We
prepare the consolidated financial statements of BluePhoenix in conformity with U.S. GAAP.
Accordingly, we are required to make certain estimates, judgments and assumptions that we
believe are reasonable based upon the information available. These estimates and
assumptions affect the reported amounts of assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses during the periods
presented. The significant accounting policies that we believe are the most critical to
aid in fully understanding and evaluating our reported financial results include the
following:

| | Revenue
recognition.Our revenue recognition policy is significant because our revenue is a
key component of our results of operations. In addition, our revenue recognition
determines the timing of certain expenses, such as commissions and royalties. We follow
very specific and detailed guidelines in measuring revenue; however, certain judgments
affect the application of our revenue policy. Revenue results are difficult to predict
and any shortfall in revenue or delay in recognizing revenue could cause our operating
results to vary significantly from quarter to quarter and could result in future
operating losses. Should changes in conditions cause management to determine that these
guidelines are not met for certain future transactions, revenue recognized for any
reporting period could be adversely affected.
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

43

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| | We
recognize revenues from direct software license agreements in accordance with statement
of position (SOP) 97-2 Software Revenue Recognition (as amended by SOP 98-4
and SOP 98-9) upon delivery of the software when collection is probable, the license fee
is otherwise fixed or determinable, and persuasive evidence of an arrangement exists.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | When
a project involves significant production, modification or customization of software, and
with respect to fixed fee contracts, revenue is generally recognized according to the
percentage of completion method in accordance with the provisions of SOP 81-1 Accounting
for performance of Construction-Type Contracts. Under this method, estimated
revenue is generally accrued based on costs incurred to date as a percentage of total
updated estimated costs. If we do not accurately estimate the resources required or the
scope of work to be performed, or do not manage our projects properly within the planned
periods of time or satisfy our obligations under the contracts, then future margins may
be significantly and negatively affected or losses on existing contracts may need to be
recognized. Any such resulting reductions in margins or contract losses could be material
to our results of operations. We recognize contract losses, if any, in the period in
which they first become evident.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Under
some of our agreements, the customer may have the right to receive unspecified upgrades
on a when-and-if available basis. These upgrades are considered post-contract customer
support, referred to as PCS, and the fair value allocated to this right, is recognized
ratably over the term of the PCS.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | There
are no rights of return, price protection or similar contingencies in our contracts.
Accordingly, we do not establish a provision due to the lack of warranties claims in the
past. Some of our contracts include client acceptance clauses. In determining whether
revenue can be recognized, when an acceptance clause exists, we consider our history with
similar arrangements, the customers involvement in the progress, the existence of
other service providers and the payments terms.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Our
revenue recognition policy does not permit any revenue recognition when the payment term
exceeds 12 months or when there is an uncertainty related to the relationship with the
customer.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Deferred
revenue includes unearned amounts received under maintenance contracts and amounts
received from customers but not yet recognized as revenues. Payments for maintenance fees
are generally made in advance and are nonrefundable.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

44

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| | Capitalized
software research and development costs.Development costs of software that is
intended for sale that were incurred after the establishment of technological feasibility
of the relevant product, are capitalized. Technological feasibility is determined when
detailed program design is completed and verified in accordance with the provisions of
the FASB Statement of Financial Accounting Standards No. 86 (SFAS 86). Software
development costs incurred before technological feasibility is established are charged to
the statement of operations as incurred net of participation of the office of the Chief
Scientist (OCS). Our policy on capitalized software costs determines the timing of our
recognition of certain development costs. In addition, this policy determines whether the
cost is classified as development expense or capitalized costs. Management is required to
use professional judgment in determining whether development costs meet the criteria for
immediate expense or capitalization. Amortization of capitalized software development
costs begins when the product is available for general release to customers. Annual
amortization is computed by the straight-line method, over the remaining useful life of
the product, or based on the ratio of current gross revenues to current and anticipated
future gross revenues, whichever is higher. Currently, amortization is computed by the
straight-line method over a period of 5 years. Our failure to accurately predict the
useful life of capitalized software could cause a one-time amortization, which could
adversely affect our operating results.
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Impairment
of goodwill and intangible assets. Our business acquisitions resulted in goodwill and
other intangible assets. We periodically evaluate our goodwill, intangible assets, and
investments in affiliates for potential impairment indicators. Our judgments regarding
the existence of impairment indicators are based on legal factors, market conditions and
operational performance of our acquired businesses and investments.
|- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | In
accordance with FASB Statement of Financial Accounting Standards No. 142 Goodwill
and Other intangible Assets (SFAS 142), effective January 1, 2002, indefinite life
intangible assets and goodwill are not amortized but rather subject to annual impairment
testing.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Goodwill
and intangible assets are tested for impairment by comparing the fair value of the
reporting unit with its carrying value. Fair value is generally determined using
discounted cash flows, market multiples and market capitalization. Significant estimates
used in the fair value methodologies include estimates of future cash flows, future short
term and long term growth rates, weighted average cost of capital and estimates of market
multiples of the reportable unit. If these estimates or their related assumptions change
in the future, we may be required to record impairment charges for our goodwill and
intangible assets. These write downs, if any, may have an adverse affect on our operating
results. Future events could cause us to conclude that impairment indicators exist and
that additional intangible assets associated with our acquired businesses are impaired.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | The
process of evaluating the potential impairment of goodwill is subjective and requires
significant judgment at many points during the analysis. In estimating the fair value of
the reporting unit for the purpose of our annual or periodic analysis, we make estimates
and judgments about the future cash flows of that reporting unit. Although our cash flow
forecasts are based on assumptions that are consistent with our plans and estimates we
are using to manage the underlying businesses, there is significant exercise of judgment
involved in determining the cash flows attributable to a reporting unit over its
estimated remaining useful life. In addition, we make certain judgments about allocating
shared assets to the estimated balance sheets of our reporting units. Changes in judgment
on these assumptions and estimates could result in a goodwill impairment charge. Any
resulting impairment loss could have a material adverse impact on our financial condition
and results of operations.
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

45

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| | Income taxes. Our income tax policy records the estimated future tax effects of
temporary differences between the tax bases of assets and liabilities and amounts reported
in the accompanying consolidated balance sheets, as well as operating loss and tax credit
carry forwards. We follow very specific and detailed guidelines regarding the
recoverability of any tax assets recorded on the balance sheet and provide any necessary
allowances as required in our management opinion, in accordance with the provisions of
FASB Statement of Financial Accounting Standards No. 109 Accounting for Income
Taxes. If we fail to accurately predict our estimated tax and if we are required to
pay higher taxes than we anticipated, our results of operations could be seriously harmed.
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Accounts
receivable. We maintain a conservative method to assure the collection of our
accounts receivable. Under this methodology, we periodically estimate the outstanding
amounts and deduct an allowance for receivables with a low collection certainty. When
there is a major deterioration of a customers credit worthiness, we make allowances
for doubtful accounts upon specific review of all outstanding invoices of such customer.
A relatively large portion of our revenue is generated from fixed-price-projects. We
recognize revenue according to the percentage of completion method, and relay on project
managers estimations in calculating that percentage. The customers payment
terms are usually based on milestones. The average debt duration is approximately 34
months, and occasionally we allow a longer payment period of up to 12 months. If we fail
to estimate accurately the recoverability of amounts due to us, our results of operations
could be adversely affected.
|- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Our Reporting Currency

Most
of our revenues and a substantial portion of our costs are denominated in United States
dollars, or dollars. The dollar is the primary currency of the economic environment in
which BluePhoenix operates. Thus the dollar is our functional and reporting currency.
Accordingly, monetary accounts maintained in currencies other than the dollar are
remeasured into dollars under the principles described in FASB Statement of Financial
Accounting Standards No. 52. Assets and liabilities have been translated at period-end
exchange rates. For non-dollar transactions reflected in the statements of operations, the
exchange rates at transaction dates are used. For consolidated companies whose functional
currency is other than the dollar, results of operations have been translated at average
exchange rates. The exchange gains and losses arising from these translations are included
in the statement of income (loss).

Following
is a summary of the most relevant monetary indicators for the reported periods:

|For the year ended
December 31, | Inflation rate in Israel | Devaluation of NIS
against the US$ | Devaluation of euro
against the US$
|------------------------------- | ------------------------ | ---------------------------------- | -----------------------------------
|
|
|
|
|2003                            | (1.9)                    | (7.6)                              | (17.0)                             
|2004                            | 1.2                      | (1.6)                              | (7.4)                              
|2005                            | 2.4                      | 6.8                                | 13.3                               

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|A. | Operating
Results
|-- | -----------------

The
following table presents the percentage relationships of certain items from our
consolidated statement of operations, as a percentage of total revenues for the periods
indicated:

Statement
of Operations Data
        as
a Percentage of Revenues:

|                                              | Year ended December 31,
|--------------------------------------------- | -----------------------
|
|
|
|
|Revenues                                      |                        
|Cost of revenues                              |                        
|                                              |                        
|Gross profit                                  |                        
|Software development costs                    |                        
|Selling, general, and administrative expenses |                        
|                                              |                        
|Operating income                              |                        
|Financial income (expenses), net              |                        
|Gain on realization of shareholdings          |                        
|Other income (expenses), net                  |                        
|                                              |                        
|Income (loss) before taxes on income          |                        
|Income tax expense                            |                        
|                                              |                        
|                                              |                        
|Minority interest                             |                        
|Equity in losses of affiliated companies, net |                        
|                                              |                        
|Net income (loss)                             |                        
|                                              |                        

# Years Ended December 31,
2005 and 2004

Revenues.           Revenues
increased 3% from $57.2 million in 2004 to $58.9 million in 2005. This           increase
was mainly in the second half of 2005 and reflects the consolidation of           I-Ter
results. We constantly update our suite of tools in order to enable a           larger
variety of languages, databases and platforms conversions. The price of a
          modernization project mainly depends on the number of lines of code to be
          converted, and is determined independently of the source and target platforms.
          As a result, the prices of our solutions do not fluctuate significantly.

The table below presents the
breakdown of our revenues based on the location of our customers for the periods
indicated:

|                            | 2005 | 2004 | 2003
|--------------------------- | ---- | ---- | ----
|
|
|
|
|United States               |      |      |     
|Europe (other than Denmark) |      |      |     
|Denmark                     |      |      |     
|Israel                      |      |      |     
|Other                       |      |      |     
|                            |      |      |     
|Total                       |      |      |     

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The
increase in sales in Europe is partially attributable to our marketing efforts during
2005, which resulted in a 19% increase in revenues in Europe (including Denmark) in 2005
compared to 2004. In addition, the consolidation of I-Ter contributed to our annual
revenues growth in Europe. In the United States there was a decrease of 15% in revenues in
2005 compared to 2004. This decrease is mainly attributable to a delay in new orders from
the North American market during the first half of 2005.

Cost
of revenues. Cost of revenues consists of salaries, travel costs relating to products
and services rendered amortization of capitalized software costs and fees paid to
independent subcontractors. Cost of revenues increased 4.6% from $24.3 million in 2004 to
$25.4 million in 2005. Cost of revenues as a percentage of revenues increased 0.7% from
42.4% in 2004 to 43.1% in 2005. The increase in cost of revenues was caused by the
increased amount of amortization of intangible assets that reached technical feasibility
during 2005. The total amount of amortization of intangible assets in 2005 was $5.5
million, as compared to $3.1 million in 2004. This increase was mostly offset by a decline
in salaries and project related costs, due to the efficient usage of our offshore delivery
centers.

Software
development costs. Software development costs, gross, consist of salaries and
consulting fees that we pay to professionals engaged in the development of new software
tools and related methodologies. Software development costs, net, consist of software
development costs, gross, less development grants and capitalized software costs.

Software
development costs, gross, increased 4% from $15.6 million in 2004 to $16.3 million in
2005. As a percentage of revenues, software development costs, gross was not changed
materially, 27.7% in 2005 compared to 27.3% in 2004.

In
the past few years, our development costs were attributed to the development of our unique
modernization suite of tools. Software development costs are charged to operations as
incurred, unless capitalized according to SFAS 86. In 2005, we capitalized software
development costs in an aggregate amount of $8.0 million compared to $7.1 million in 2004.
This increase was primarily due to the implementation of our strategy to expand our tool
offerings and increase the degree of automation of our tools. These factors are important
in order to maintain our leadership position in the market and perform profitable
projects.

Selling,
general and administrative expenses. Selling, general and administrative expenses
consist primarily of wages and related expenses, travel expenses, third party and sales
people commissions, selling expenses, marketing and advertising expenses, rent, insurance,
utilities, professional fees, and depreciation. Selling, general and administrative
expenses increased from $21.4 million in 2004 to $21.6 million in 2005. During 2005, our
management members devoted significant marketing efforts in order to further expose the
Companys suite of tools to potential customers and partners.

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Financial
income (expenses), net. Financial expenses in 2005 were $2.0 million compared to
$882,000 in 2004. A portion of the increase in financial expenses is due to the issuance
of convertible debentures in March 2004, which was partially included in financial
expenses in 2004 and fully accounted for in the first quarter of 2005, when a registration
statement covering the underlying shares became effective. In addition, the increase in
financial expenses is attributable to (i) the increase of the companys overall
borrowings from banks, and (ii) the devaluation of the euro conversion rate compared to
the dollar in 2005 by 13.3%, as compared to a 7.4% increase in the euro conversion rate in
2004.

Gain
on realization of shareholdings. There was no gain on realization of shareholdings in
2005. Gain on realization of shareholdings in 2004 was $112,000. This gain results from a
sale of ordinary shares of Level 8 was $171,000. This gain was partially offset by a loss
of $59,000 resulted from transaction-related costs with respect to the sale of our
shareholdings in Tesnet  Software Testing Ltd., or Tesnet. The sale of Tesnets
shares was for cash consideration of $2.8 million.

Other
income, net.Other income, net in 2005 was $104,000 compared to $975,000 in 2004.
Other income in 2004 consists primarily of a $703,000 dividend received from Steps
Ventures.

Income
tax expense. In 2005, we had an income tax expense of $149,000 compared to $260,000 in
2004. Due to tax losses carried forward in Israel and in several other locations, our
total tax expense is composed of the net aggregate expense of local taxes paid worldwide
by our international subsidiaries.

Share
in losses of affiliated companies, net. In 2004, share in losses of affiliated
companies, net, was $516,000. Share in losses of affiliated companies in 2004 was mainly
attributable to $69,000 representing our share in the losses of Intercomp, and $455,000
representing our share in the losses of MultiConn Technologies. In 2005, these two
affiliates were consolidated in our result of operations, and therefore no equity in
losses of affiliated companies was recorded.

Minority
interests in profits of subsidiaries. Minority interest in 2005 includes $137,000
representing the minority share in the profits of Mainsoft, and $2,000 representing the
minority share in the profits of Liacom Systems.

Years Ended December 31,
2004 and 2003

Revenues.          Revenues
increased 5.2% from $54.3 million in 2003 to $57.2 million in 2004.           This
increase reflected the initial results of our marketing efforts. In           addition,
preliminary recovery symptoms in the markets in which we operate, led           to
increased IT spending, which in turn increased the volume of our           services and
products sales. The prices of our products and services           have not changed
significantly during the recent three years, and price           fluctuations had no
material impact on our revenues.

We
had a relatively low increase in our sales in the United States and a decrease in our
sales in Europe (other than Denmark). This was mainly attributable to the worldwide slow
recovery of the IT industry.

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Cost
of revenues. Despite the overall growth in the volume of our activities, cost of
revenues increased only 0.6% from $24.1 million in 2003 to $24.3 million in 2004. Cost of
revenues as a percentage of revenues decreased to 42.4% in 2004 compared to 44.4% in 2003.
The increase in our gross margins is mainly attributable to the increased usage of our
offshore low-cost development and delivery centers in Romania and Cyprus. Due to the lower
average employers costs in these sites, we have reduced the overall cost of
programmers, which resulted in the decrease of our cost of revenues and the resultant
increase in our gross margins.

Software
development costs. During 2004, our subsidiaries received an aggregate of
approximately $470,000 in grants from the OCS and the Singapore-Israel Industrial Research
and Development Foundation for the development of the funded products.

Software
development costs, gross, increased 28% from $11.9 million in 2003 to $15.6 million in
2004. As a percentage of revenues, software development costs, gross increased to 27.3% in
2004 compared to 21.8% in 2003. This increase was primary due to the implementation of our
strategy to expedite the development of our solutions in an effort to maintain our
leadership position in our market.

During
2004, our development costs were attributed to the development of our unique modernization
suite of tools. Software development costs are charged to operations as incurred, unless
capitalized according to SFAS 86. In 2004, we capitalized software development costs in an
aggregate amount of $7.1 million compared to $3.2 million in 2003. Software development
costs, net, decreased to 14.1% in 2004 compared to 15.0% in 2003. Net software development
costs related to development of tools through our affiliates are included in our
consolidated financial statements under Equity in Losses of Affiliated Companies,
Net.For a description of our research and development activities, see
Item 4.B. Business Overview  Research and Development.

Selling,
general and administrative expenses. Selling, general and administrative expenses
increased 6.2% from $20.1 million in 2003 to $21.4 million in 2004. As a percentage of
revenues, selling, general and administrative expenses increased to 37.4% in 2004 compared
to 37.0% in 2003.

Financial
income (expenses), net. Financial expenses, net in 2004 were $882,000 compared to
financial income, net of $165,000 in 2003. In 2004, financial expenses, net included the
impact of the issuance of the $5 million convertible debentures and other long term
convertible debt resulting in a net expense of $688,000.

Gain
on realization of shareholdings. Gain on realization of shareholdings in 2004 was
$112,000 compared to a gain of $376,000 in 2003. In 2004, we sold substantially all of the
ordinary shares of Level 8 then held by us. The gain realized from the sale of these
shares was $171,000. This gain was partially offset by a loss of $59,000 resulted from the
sale of our shareholdings in Tesnet. The sale of Tesnets shares was for cash
consideration of $2.8 million, and the $59,000 loss is mainly attributable to transaction
related costs. Gain on realization of shareholdings in 2003 is attributable to the
conversion of preferred shares of Level 8 into common shares of Level 8 and their
subsequent sale. The gain realized from the sale of these shares was $376,000.

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Other
income, net.Other income, net in 2004 was $975,000 compared to $567,000 in 2003.
Other income, net in 2004 consisted primarily of a $703,000 dividend received from Steps
Ventures.

Income
tax expense. In 2004, we had an income tax expense of $260,000 compared to an income
tax expense of $152,000 in 2003. This net aggregate expense was composed of local taxes
paid worldwide by our international subsidiaries.

Share
in losses of affiliated companies, net. In 2004, share in losses of affiliated
companies, net, was $516,000. Share in losses of affiliated companies in 2004 was mainly
attributable to $69,000 representing our share in the losses of Intercomp, and $455,000
representing our share in the losses of MultiConn Technologies. In 2003, share in losses
of affiliated companies, net, was $898,000. Share in losses of affiliated companies in
2003 included an aggregate amount of $898,000 representing our share in the losses of our
affiliate Intercomp, and an amount of $200,000 representing our share in the losses of our
affiliates M.S.I. MultiConn and MultiConn Technologies, partially offset by $200,000
representing our share in the gains of Tesnet.

Minority
interest. In 2004, minority interest was $73,000. Minority interest in 2004 included
$51,000 representing the minority share in the losses of Liacom Systems, and $22,000
representing the minority share in the losses of Mainsoft.

|B. | Liquidity
and Capital Resources
|-- | -------------------------------

# How We Have Financed Our Business

In
1997, we consummated two public offerings, and received net proceeds of $33.9 million
after deducting underwriting discounts and commissions and offering expenses.

On
March 30, 2004, we completed a $5 million private placement to institutional investors.
Under the terms of this transaction as amended on February 18, 2005, we issued to the
institutional investors convertible debentures due in 2007, bearing interest at a rate of
LIBOR calculated on a semi-annual basis. Pursuant to our agreement with the institutional
investors, in March 2006, the institutional investors exercised their right to purchase
from us additional convertible debentures and warrants for an aggregate purchase price of
$3 million. Those debentures are due in 2009. For more information regarding the private
placement, see  Contractual Commitments and Guarantees.

In
February 2006, we completed an underwritten public offering in Israel of series A
convertible notes in an aggregate principal amount of $11.5 million. Interest on the notes
is LIBOR 3 months +1.5% per annum. The interest is payable every 3 months beginning on May
1, 2006, with the last payment to be made on February 1, 2011. The principal of the notes
is payable in four equal annual installments on February 1 of each of 2008 through 2011.
The notes are convertible into BluePhoenixs ordinary shares at a conversion rate of
one ordinary share per $5.52 principal amount of notes. The notes are traded on the TASE.
For more information regarding the series A convertible notes, see Item 4.A. History
and Development of the Company  Recent Developments.

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We
have entered into credit facilities with Bank Discount LeIsrael Ltd., Bank
HaPoalim Ltd. Bank Leumi LeIsrael Ltd. and the First International Bank Ltd.,
of up to an aggregate of $22 million. The aggregate amount outstanding under these credit
facilities as of December 31, 2005 was $18.8 million, and as of March 24, 2006 was $11.8
million. We may use these credit facilities from time to time for interim financing, in
accordance with our cash requirements. These credit facilities provide for loans in
various currencies and bear various interest rates. In connection with these credit
facilities extended to us by these banks, we are committed to certain covenants related to
our operations, such as:

| |  | maintaining
a minimum level of shareholders' equity of no less than 40% of our total assets and no
less                   than $40 million;
| | - | -------------------------------------------------------------------------------------------------------------------------------------------

| |  | maintaining
a level of annual operating income before depreciation and amortization of no less than
$5                   million; and
| | - | -------------------------------------------------------------------------------------------------------------------------------------

| |  | maintaining
a ratio of our bank liabilities to current assets, excluding other current assets, of no
more than 55%.
| | - | -------------------------------------------------------------------------------------------------------------------

To
date, we have met all such covenants.

|On
December 31, 2005, we had cash and cash equivalents of $10.8 million and working capital
of $4.5 million. On December 31, 2004, we had cash and cash equivalents (including
marketable securities) of $9.5 million and working capital of $6.4 million.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Net
cash provided by operating activities was $5.2 million in 2005 compared to $1.1 million in
2004. Cash provided by operating activities in 2005 was primarily the result of add-backs
from depreciation and amortization. This was partially offset by a decrease in payables
and an increase in trade receivables. Cash provided by operating activities in 2004 was
primarily the result of our $2.8 million net income and add-backs due to depreciation and
amortization of capitalized expenses and other intangible assets. This was partially
offset by a decrease in other payables and an increase in trade receivables.

Liraz
has a fixed charge in favor of a bank on certain of its assets, as well as a floating
charge on its entire assets, securing our long-term credit facility of $8 million. This
credit facility also covers a guarantee of $2 million in the aggregate that we extended to
banks relating to the credit line of Level 8. For more information, see Item 4.B.
Business Overview  Investments and Acquisitions  Level-8.

In
connection with the purchase of Outlook Systems Ltd.s software development services
activity, in 2004, we extended a guarantee to a bank with respect to loans in an aggregate
amount of $720,000 plus interest accrued. In the first quarter of 2006, following an
amendment to the Outlook Systems agreement, our guarantee expired. For more information
related to our agreement with Outlook Systems, see Item 4.B. Business Overview
 Investments and Acquisitions  Outlook.

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Typical
modernization projects, which deploy our solutions, are long-term projects, and therefore,
payment for these projects or a substantial portion of our fees may be delayed until the
successful completion of specified milestones and customer acceptance for the completed
work. During 2004, we mutually agreed with a customer, to terminate a contract. The
contract was accounted for under the percentage of completion method. As a result, we
recorded a loss of $400,000 in the first quarter of 2004. The payment of our fees is
generally dependent upon customer acceptance of the completed work, and our ability to
collect the fees. Further, although the timing of receipt of our fees varies, we incur the
majority of our expenses on a current basis. As a result, a delay in the collection of our
fees could result in cash flow shortages.

Capital Expenditures

Our
capital expenditures were $700,000 in 2005 and $1.1 million in 2004. Our capital
expenditures in these years related primarily to purchases of computers and related
equipment required to support our software development activities. In 2005 and 2004, we
invested $370,000 and $97,000 in other companies. In 2003, we lent $1.1 million to
affiliated companies.

In
2002, we purchased a 90% controlling interest in Liraz through a share exchange
transaction that was followed by a cash tender offer. We paid for the tendered shares
aggregate consideration of $1.1 million. During 2003, we completed an additional tender
offer and purchased the remaining outstanding share capital of Liraz for an aggregate of
$1.5 million.

In
the last three years, we did not repurchase any shares under our buy-back programs. As of
December 31, 2005, we had repurchased 1,870,565 of our ordinary shares under our buy-back
programs, for an aggregate of approximately $14.7 million. In January 2006, we sold an
aggregate of 136,000 of the shares held by one of our subsidiaries to Israeli
institutional investors in Israel, for aggregate consideration of approximately $560,000.
In February 2006, we sold 86,971 shares held by one of our subsidiaries to Outlook Systems
Ltd.; see Item 4.B. Business Overview  Investments and Acquisitions 
Outlook. Under our buy-back programs, we may purchase our shares from time to time,
subject to market conditions and other relevant factors affecting us. Under the Companies
Law, the repurchased shares do not confer upon our subsidiaries any voting rights
(although they entitle their holders to participation rights upon distribution). The first
buy-back program adopted in May 1998 enables us to purchase our shares, through a
subsidiary, utilizing up to $5.0 million. Under the second buy-back program adopted in
September 1998, and amended in May 1999, we may purchase, through a subsidiary as a
trustee, up to an additional 2,000,000 ordinary shares. Under the two plans we may acquire
an additional 1,089,026 shares at the current stock price. The closing price of our
ordinary shares as quoted on the NASDAQ National Market on March 24, 2006 was $5.00. Under
the agreement we entered into in connection with the private placement in March 2004, we
are restricted to use only up to $200,000 for the repurchase of our shares, as long as 20%
or more of the debentures are outstanding.

We
believe that cash generated from operations together with existing sources of liquidity
and cash flow, will be sufficient to meet our anticipated cash needs for at least the next
18 months.

53

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# Contractual Commitments
and Guarantees

Convertible
Debentures Issued in a Private Placement to Institutional Investors

On
March 30, 2004, we completed a $5 million private placement of convertible debentures and
warrants to four institutional investors. On February 18, 2005, the institutional
investors and we amended certain terms of the transaction. Pursuant to the amended
agreements, the debentures are due in 2007 and bear interest at a rate equal to the
six-month LIBOR, paid quarterly in cash or in a number of BluePhoenix ordinary shares, at
our discretion. The debentures are convertible into BluePhoenixs ordinary shares at
a conversion rate of $5.25 per ordinary share, subject to (i) adjustment for stock
dividends, stock splits, recapitalization and other similar events; and (ii) anti-dilution
adjustments. Following an event of adjustment in January 2006, the conversion rate of the
debentures was adjusted to $5.24 per ordinary share. The conversion rate with respect to
payments of interest on the debentures will be equal to 90% of the volume weighted average
price of our ordinary shares on the NASDAQ National Market during the 20 trading days
preceding the date of payment of interest. In the event the volume weighted average price
per ordinary share (as calculated in the preceding sentence) for any 20 consecutive
trading days exceeds $6.55, then we may force the holders of the debentures to convert any
or all of the principal amount of the debentures held by them as of such date, subject to,
among other things, our having an effective resale registration statement at such time for
the resale of the ordinary shares underlying the debentures.

In
addition to the debentures, the institutional investors were issued warrants to purchase
up to 285,714 BluePhoenix ordinary shares at an exercise price of $6.50 per share, subject
to adjustments similar to those pertaining to the conversion price of the debentures. The
warrants are exercisable during a 5 years period commencing in September 2004.

Pursuant
to our agreement with the institutional investors, in March 2006, three of the investors
exercised their right to purchase from us additional debentures and warrants. Accordingly,
we issued to the investors debentures at an aggregate purchase price of $3 million on the
same terms as the initial debentures, except that the conversion price is $4.50 per share
and due in 2009. In addition, the institutional investors were issued additional warrants
on the same terms as the initial warrants, to purchase an aggregate of up to 200,000 of
our ordinary shares. The warrants are exercisable during a 5 years period commencing in
September 2006. Under our agreement with the institutional investors, we are obligated to
file a registration statement on Form F-3 within 45 days from the closing, and the
registration statement is required to be declared effective within 90 days after we filed
it (or 120 days in the event of a review by the SEC).

If
the additional debentures issued to the institutional investors are fully converted the
applicable interest is paid in cash, and the additional warrants are fully exercised, we
would be required to issue to the investors up to 866,667ordinary shares, subject to
adjustments.

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Series
A Convertible Notes Offered to the Public in Israel

In
February 2006, we completed an underwritten public offering in Israel of series A
convertible notes in an aggregate principal amount of $11.5 million. Interest on the notes
is LIBOR 3 months +1.5% per annum. The interest is payable every 3 months beginning on May
1, 2006, with the last payment to be made on February 1, 2011. The principal of the notes
is payable in four equal annual installments on February 1 of each of 2008 through 2011.
The notes are convertible into BluePhoenixs ordinary shares at a conversion rate of
one ordinary share per $5.52 principal amount of notes. The notes are traded on the TASE.
For more information regarding the series A convertible notes, see Item 4.A. History
and Development of the Company  Recent Developments.

Other
Contractual Commitments and Guarantees

In
December 2003, Mainsoft entered into an Independent Contractor Agreement with Microsoft.
As a result of this agreement, Microsoft agreed to apply the value of Mainsofts
services performed under the Independent Contractor Agreement to accrued royalties up to
$1,605,000. During the year ended December 31, 2005, Mainsoft accrued royalties due to
Microsoft of $485,000, and recognized credits of $18,000 related to waivers (reduction of
cost of revenues) and credits of $52,000, related to services performed (increase in
revenues). During the year ended December 31, 2004, Mainsoft accrued royalties due to
Microsoft of $325,000, and recognized credits of $125,000 related to waivers (reduction of
cost of revenues) and credits of $635,000 related to services performed (increase in
revenues).

Under
funding agreements three of our subsidiaries have entered into with the Office of the
Chief Scientist (OCS), these subsidiaries are obliged to pay royalties to the OCS at a
rate of 3% on sales of the funded products, up to 100% of the dollar-linked grant received
in respect of these products from the OCS. As of December 31, 2005, the aggregate amount
of grants received by our subsidiaries from the OCS was $2.2 million.

In
the first quarter of 2004, the Singapore-Israel Industrial Research and Development
Foundation agreed to provide one of our wholly owned subsidiaries together with a company
incorporated in Singapore, financing for the development of a Java report generator
software tool. Accordingly, the foundation agreed to award our subsidiary up to $100,000
payable according to an agreed upon schedule. As of March 24, 2006, we received $30,000 of
the grant. The grant is required to be repaid in installments based on sales of the funded
software up to the amount of the grant.

Our
subsidiary, I-Ter, is entitled to funds to develop Easy4Plan product, from the Ministry of
Production in Italy. Easy4Plan is a workflow management tool designed for ISO9000
companies. Approximately 30% of the funds are a grant, and the balance is an 8-year loan
to be repaid by I-Ter. The loan bears a minimal annual interest. The development term ends
in July 2006. We anticipate that during 2005 and 2006 I-Ter will receive a total aggregate
amount of $600,000.

55

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We
are obligated to pay to Formula management fees in an annual amount equal to 3% of our
revenues, but no more than the NIS equivalent of $180,000. For more information see
Item 7. Major Shareholders and Related Party Transactions  Related Party
Transactions  Management Agreement with Formula.

Under
agreements between us and certain of our customers, we undertook to provide such customers
bank guarantees for the assurance of performance of our obligations under our agreements
with such customers. As of March 24, 2006, there are outstanding bank guarantees on our
behalf for our customers in the aggregate amount of $225,000.

We
are committed under operating leases for rental of office facilities, vehicles and other
equipment for the years 2006 until 2011. Annual rental fees under current leases are
approximately $2.9 million, and are expected to remain at this level for each of the next
three years. In connection with the office leases, we issued bank guarantees of $105,000
in the aggregate.

During
2000, Liraz provided a bank guarantee to secure a loan to Level 8. Liraz recorded a
provision of the maximum potential amount of future payment because the realization of the
guarantee was reasonably foreseeable. The guarantee is outstanding until November 2006. In
the event that the guarantee is exercised, the bank is obligated to grant us a three years
loan in an amount of up to the amount of the guarantee. As of December 31, 2005, this
guarantee amounted to approximately $2.0 million. For more information, see Item
4.B. Business Overview  Investments and Acquisitions  Level-8.

In
connection with the purchase of Outlook Systems Ltd.s software development services
activity in 2004, we extended a guarantee to banks with respect to loans in an aggregate
amount of $720,000 plus interest accrued. In the first quarter of 2006, following an
amendment to the Outlook Systems agreement, our guarantee expired. For more information,
see Item 4.B. Business Overview  Investments and Acquisitions 
Outlook.

In
January 2001, we granted FIMI, a creditor of Intercomp, a put option to sell to us
promissory notes issued by Intercomp in an aggregate principal amount of $3.5 million plus
interest accrued since January 2001 at an annual rate of 5%, which could be paid, subject
to FIMIs approval, in BluePhoenixs ordinary shares. The total outstanding
amount of principal and interest accrued as of December 31, 2005 was $4.3 million. In
August 2003, the terms of FIMIs option were amended, allowing FIMI to exercise its
option in three installments during June 2004, June 2005 and June 2006. In the first
quarter of 2006, FIMI completed exercising all three installments for cash, and
concurrently, reached an agreement with us for early payment for the promissory notes.
Accordingly, we purchased from FIMI the promissory notes for an aggregate amount of $4.48
million including interest accrued. As part of the consideration, we issued to FIMI
warrants to purchase 210,000 BluePhoenixs ordinary shares exercisable until June 30,
2007, at an exercise price of $4.00 per share.

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In
April 2004, a shareholder of Intercomp comprised of several funds acting through their
general partner, Infinity, granted us a call option to purchase its entire holdings in
Intercomp, exercisable until April 1, 2006. If we do not exercise such option, Infinity
will have a put option to cause us to purchase Infinitys entire holdings in
Intercomp, exercisable during a period of six months commencing in April 2006. If either
of the options is exercised, we shall be obliged to issue to Infinity, as consideration
for Intercomps shares, 100,000 BluePhoenixs ordinary shares and an additional
amount of shares to be calculated based on revenues generated from the sale of licenses to
use Intercomps products during a 3-year period commencing on April 1, 2003. We may,
at our option, pay to Infinity the cash equivalent of such shares that will be calculated
according to the average closing price of BluePhoenixs shares during the 20 trading
days prior to the exercise of any of the options.

In
February 2003, the Israeli Income Tax Authorities issued to BluePhoenix an income tax
assessment for the tax year ended December 31, 1997 in the amount of approximately $1.5
million. Following an appeal we filed on this assessment, we received a revised tax
assessment for the tax years ended December 31, 1997 through 2001 of approximately $1.2
million, of which approximately $1 million has been already paid by us. Based on
consultation with our tax counsel, we believe that while the outcome of any controversy
cannot be predicted with complete certainty, the final payment will not exceed $1.1
million. This tax expense is fully offset against previously existing tax reserves and
will not have a material adverse effect on our financial statements as a whole.

We
entered into an undertaking to indemnify our office holders in specified limited
categories of events and in specified amounts, subject to certain limitations. For more
information, see Item 7.B. Related Party Transactions  Indemnification of
Office Holders.

Effective Corporate Tax
Rates

In
1996, 1997 and 1998, certain of our operations were granted approved
enterprise status under the Law for the Encouragement of Capital Investments 
1969, known as the Investments Law. If we comply with all requirements, we shall be
eligible for certain tax benefits with respect to these operations, for the first seven
years in which they generate taxable income. Income derived from our approved enterprise
programs will be tax exempt for a period of two years after we have taxable income, and
will be subject to a 25% company tax rate for the following five years. We completed the
tax exemption period of some of our qualified approved enterprise operations
and, therefore, these operations are subject to a 25% income tax commencing 1999. If the
percentage of our share capital held by foreign shareholders exceeds 25%, future approved
enterprises would qualify for reduced tax rates for an additional three years, after the
seven years mentioned above. However, we cannot assure you that we will obtain additional
approved enterprise status for our operations, or that the provisions of the
Investments Law will not change, or that the above-mentioned shareholding portion will be
reached or maintained for each subsequent year.

On
January 1, 2003, Israels tax laws underwent a significant tax reform (Amendment 132
to the Income Tax Ordinance (New Version)  1961). The legislation broadened the
categories of taxable income, and reduced the tax rates imposed on employment income.
Among the key provisions of this legislation were (i) changes that may result in the
imposition of taxes on dividends received by an Israeli company from its foreign
subsidiaries; and (ii) the introduction of the controlled foreign corporation concept
according to which an Israeli company may become subject to Israeli taxes on certain
income of a non-Israeli subsidiary if the subsidiarys primary source of income is
passive income (such as interest, dividends, royalties, rental income or capital gains).
An Israeli company that is subject to Israeli taxes on the income of its non-Israeli
subsidiaries will receive a credit for income taxes paid by the subsidiary in its country
of residence.

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On
January 1, 2006, an additional tax reform has been taken place relating primarily to
profits from investments. The main goal of the reform was to unify the tax rates
applicable to profits from investments, such as interest, capital gains and dividends. In
addition, under the new reform, the tax rates applicable to companies were reduced to 31%
in 2006, 29% in 2007, 27% in 2008, 26% in 2009 and 25% in 2010.

Our
international operations are taxed at the local effective corporate tax rate in the
countries of our subsidiaries residence. We believe that in the future we will
derive an increasing percentage of our income from operations outside of Israel and that,
accordingly, our effective tax rate may increase. However, we expect that this increase
will be offset by carried forward accumulated losses of consolidated companies. As a
result, we anticipate that our net effective tax rate in the foreseeable future shall be
lower than 25%.

|C. | Research
and Development, Patents and Licenses
|-- | ----------------------------------------------

For
a description of our research and development activities, see "Item 4.B. Business
Overview - Research and Development."

For
information concerning our intellectual property rights, see Item 4.B. Business
Overview  Intellectual Property.

|D. | Trend
Information
|-- | -----------------

We
have been affected by global economic changes, in particular the sharp decline in 2001 and
2002, in capital spending in the IT sector and the overall business slowdown in North
America and Europe, as well as in Israel. Uncertainties in the North American and European
markets have influenced the purchasing patterns of leading software developers who delayed
their planned orders and caused developers to reduce the amount of their planned license
commitment. These changes in purchasing patterns in the IT industry directly affect our
operating results. Our revenues decreased from $49.2 million in 2000 to $38.4 million in
2001 and to $36.7 million in 2002. In the last three years, as a result of a slight
recovery of the market, and the impact of a strategic acquisition we completed, this trend
changed, and our revenues increased to $54.3 million in 2003, $57.2 million in 2004 and
$58.9 million in 2005. We cannot know whether the global market will recover in the
future, and how the economic conditions will continue to affect our business. As we
continue to market new products and penetrate international markets, we expect our
selling, general and administrative expenses to continue to be relatively high.

In
March 2003, we completed the acquisition of the entire outstanding share capital of Liraz.
In 2004, we concluded the integration of all managerial and field functions of Liraz
within ours. We expect that as a result of the integration of our business with that of
Liraz, the combined companies will be able to realize greater operating efficiencies and
will benefit from a broader product line with a larger and more diversified marketing and
support network. In addition, we anticipate that the combination of our respective
technical personnel will enhance our product development capabilities.

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|E. | Off-Balance
Sheet Arrangements
|-- | ------------------------------

| | On
March 15, 2005, as the Form F-3 relating to the convertible debentures was declared
effective by the Securities Exchange Commission (see Item 5.B.  Contractual
commitments and Guarantees), the Company classified the fair value attributed to
the warrants as equity. The warrants were revaluated to their fair value until such date.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Regarding
the contingent consideration related to acquisitions  see Item 4.B. Business
Overview  Investments and Acquisitions  Outlook, I-Ter, CePost.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------

|F. | Tabular
Disclosure of Contractual Obligations
|-- | ---------------------------------------------

The
following table summarizes our contractual obligations and commitments as of December 31,
2005:

|                            | Payment due by period
|--------------------------- | ---------------------
|
|
|
|
|Long term debt obligations  |                      
|Operating lease obligations |                      
|                            |                      
|Total                       |                      

The
above table does not include royalties that we may be required to pay to the OCS and that
may reach, in the aggregate, as of December 31, 2005, $2.2 million (see Item 4.B.
Business Overview  Research and Development). We are unable to reasonably
estimate the time and the amounts that we will eventually be required to pay to the OCS,
if at all, since these amounts depend on our ability to sell products based on the
OCS-funded technologies and the timing of such sales, if any.

|G. | Safe
Harbor
|-- | -----------

The
safe harbor provided in Section 27A of the Securities Act and Sections 21E of the Exchange
Act shall apply to forward-looking information provided in Items 5.E and F.

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|ITEM 6. | DIRECTORS,
SENIOR MANAGEMENT, AND EMPLOYEES
|------- | -------------------------------------------

|A. | Directors
and Senior Management
|-- | -------------------------------

The
following table describes information about our executive officers and directors as of
March 24, 2006.

|Name                    | Age | Position                         
|----------------------- | --- | ---------------------------------
|
|
|
|
|Gad Goldstein           | 47  | Chairman of the Board            
|Aaron Crystal           | 62  | Director                         
|Arie Kilman             | 53  | Chief Executive Officer, Director
|Iris Yahal              | 45  | Chief Financial Officer, Director
|Dan Goldstein           | 52  | Director                         
|Shai Beilis             | 57  | Director                         
|Naamit Salomon          | 41  | Director                         
|Gur Shomron             | 53  | Director                         
|Michael Chill (1)       | 39  | Director                         
|Amira Berkovitz-Amir(1) | 39  | Director                         

---

(1) An outside director

Gad
Goldstein has served as a chairman of our board of directors since April 1998 and as a
director of Formula since January 1985. Mr. Goldstein was the vice president of Formula
from 1985 through 1995 and was appointed president of Formula in 1995. He is also a
director of other companies within the Formula Group, including Matrix IT Ltd., or Matrix,
Magic Software Enterprise Ltd., or Magic, Formula Vision Technologies (F.V.T.) Ltd. and
Sapiens International Corporation N.V., or Sapiens, all of which are publicly traded
companies. Mr. Goldstein holds a BA in economics and an MA in business administration,
both from Tel Aviv University. Gad Goldstein is the brother of Dan Goldstein, one of our
directors.

Aaron
Crystal founded our company (previously named Crystal System Solutions Ltd.) in 1987,
and served as our Chief Executive Officer through 1996 and President through March 2005.
Mr. Crystal has served as one of our directors since our formation. Between November 1999
and December 2004, he also served as vice chairman of our board of directors. From 2004,
Mr. Crystal has served as Chairman of the board of a privately held software company,
Cogniview Ltd. From 1983 to 1987 Mr. Crystal was vice president, technical support of
Mehish Computer Services.

Arie
Kilmanhas served as our chief executive officer since May 2003. Mr. Kilman has also
served as president and chief executive officer of BluePhoenix Solutions B.V. since its
inception in October 2001. Mr. Kilman previously served as the president of Liraz, which
he founded in 1984, and managed since then. From 1998 to 2000, Mr. Kilman served as chief
executive officer of Level 8. Mr. Kilman holds a BA degree in economics and computer
science from New York University.

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Iris
Yahal has served as one of our directors since January 1, 1999 and as our chief
financial officer since October 1995. In addition, Ms. Yahal served as the controller of
several other Formula subsidiaries until December 1996. From 1991 until 1996, Ms. Yahal
served as the controller of Transtech Control Ltd., a subsidiary of Formula. Prior to
1991, Ms. Yahal worked as an auditor with Wallenstein and Co., a public accounting firm.
Ms. Yahal holds a BA in accounting and an MA in business administration, both from Tel
Aviv University, and is a certified public accountant in Israel.

Dan
Goldstein has served as one of our directors since March 1993. Mr. Goldstein has
served as chairman of the board of directors and chief executive officer of Formula since
1985. Mr. Goldstein is also chairman of the board of Formula Vision and Matrix and is a
director of other Formula group companies, including Magic and Sapiens. Mr. Goldstein
holds a BA in mathematics and computer sciences and an MA in business administration, both
from Tel Aviv University. Dan Goldstein is the brother of Gad Goldstein.

Shai
Beilis served as chairman of our board of directors from December 1995 until April
1998 and as vice chairman of our board of directors from April 1998 until November 1999.
Mr. Beilis continues to serve as one of our directors. Mr. Beilis currently serves as
chairman and chief executive officer of Formula Ventures Ltd., a venture capital fund
manager, member of the Formula group. Mr. Beilis also served as a director of Formula from
December 1997 to February 2005. From July 1993 to the beginning of 1995, Mr. Beilis served
as the managing director of Clal Computers and Technology Ltd., an Israeli information
technology company. Mr. Beilis holds a B.Sc. in mathematics and economics from the Hebrew
University in Jerusalem and an MA in computer science from the Weizmann Institute of
Science.

Naamit
Salomonjoined our board of directors in December 2004. Ms. Salomon has served as vice
president, finance of Formula since August 1997. Ms. Salomon also serves as a director of
Magic and Sapiens. From 1990 through August 1997, Ms. Salomon was a controller of two
privately held companies in the Formula Group. Ms. Salomon holds a BA degree in economics
and business administration from Ben Gurion University and an LLM degree from Bar-Ilan
University.

Gur
Shomron joined our board of directors and appointed as a member of our audit committee
in July 2005. Mr. Shomron serves as the chairman of the board of directors of Fidelis
Diagnostics Inc. since 2004. Prior to that, Mr. Shomron served as Venture Partner at
StageOne VC fund. Mr. Shomron is also a management consultant for Bet Israel 101 Ltd. and
serves as a director of our subsidiary, Mainsoft, and of several other privately-held high
technology companies.

Michael
Chillhas served as one of our independent directors and a member of our audit
committee since July 2003. From July 2005, Mr. Chill has served as Co-head of the Direct
Investments at Paramount Biocapital Asset Management Inc, a venture capital hedge fund and
broker dealer. Prior to that, Mr. Chill served as an analyst and independent advisor to
various high technology companies and venture capital firms both in Israel and the United
States. During 2000 and the first half of 2001, Mr. Chill served as the president and head
of investment banking department at Jerusalem Global Ltd., a venture capital and
investment banking firm. Prior to that, from 1999, Mr. Chill served as a managing director
in the technology investment banking group at Gruntal and Co. Mr. Chill holds a B.S. in
accounting from the Sy Syms School of Business at Yeshiva University and an MBA from the
Columbia Business School.

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Amira
Berkovitz-Amir has served as one of our outside directors and as a member of our audit
committee since December 2004. Until October 2005, Ms. Berkovitz-Amir served as vice
president, finance of Of-Tov Products (2001) Ltd., a manufacturer in the food industry and
a member of Osem Industries Group. Previously, Ms. Berkovitz-Amir served as vice
president, finance and controller of Pri-Hagalil Industries, a manufacturer in the food
industry. Ms. Berkovitz-Amir holds a BA degree in economics and accounting and an MA in
business administration, both from the Hebrew University. Ms. Berkovitz-Amir is a
certified public accountant in Israel.

|B. | Compensation
|-- | ------------

In
2005, we paid to our outside directors and executive officers aggregate remuneration of
approximately $493,024. This amount includes amounts set aside or accrued to provide
pension, social security or similar benefits but does not include amounts expended by us
for automobiles made available to our officers and expenses (including business travel,
professional and business association dues and expenses) reimbursed to officers. Under
Israeli law, we are not required to disclose, and have not otherwise disclosed, the
compensation of our senior management and directors on an individual basis.

The
aggregate remuneration set forth in the foregoing paragraph does not include amounts we
paid to Formula under the terms of a management agreement, as consideration for management
services rendered to us by certain directors designated by Formula. These directors
currently include Gad Goldstein, Dan Goldstein and Naamit Salomon.  See Item 7.B. Related Party
Transactions.

We
maintain written employment agreements with Arie Kilman and Iris Yahal. Our employment
agreement with Aaron Crystal terminated in March 2005. The employment agreements are not
for a specific term and we may terminate any of them upon prior notice of between three
and six months. If we terminate any of these employment agreements, we will have to pay
the usual severance pay required under Israeli law for all employees. The directors are
not entitled to any other benefits upon termination. These agreements provide for annual
base salaries and other benefits like vacation, sick leave, provision of automobiles,
insurance contributions, and non-compete and confidentiality agreements. The agreements
also entitle Mr. Kilman and Ms. Yahal to bonuses based on achieving targets set by our
board of directors.

Mr.
          Kilman, in his former position as Lirazs chairman of the board of
          directors was granted by Liraz in May 2002 a loan in an amount equal to
          approximately $300,000, linked to the Israeli consumer price index, and bearing
          annual interest at a rate of 4%. Under the terms of the loan, the loan should
be           repaid to Liraz in four equal annual installments until 2006, but no later
than           termination of Mr. Kilmans employment. Mr. Kilman pledged in favor
of           Liraz 200,000 Lirazs shares he owned as a security for repayment of
the           loan. Following the share exchange transaction between us and Lirazs
          shareholders, effective as of November 14, 2002, Mr. Kilman replaced the
pledged           shares with 119,760 BluePhoenix shares. The amount of BluePhoenix
shares pledged           by Mr. Kilman was based on the exchange ratio determined in the
share exchange           agreement, pursuant to which every 1.67 shares of Liraz were
exchanged for one           BluePhoenix ordinary share. Except for the replacement of the
pledged shares,           the terms of the loan were not amended in any way. As of March
24, 2006, Mr.           Kilman repaid $225,000 of the principal amount of the loan plus
linkage           differentials and accrued interest. Accordingly, 75% of the pledged
shares were           released from the pledge. To date, Mr. Kilman has complied with all
loan payment           obligations under the loan agreement. An amount of $95,500
(including linkage           differentials and accrued interest) is still outstanding.

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|C. | Board
Practices
|-- | ---------------

Pursuant
to our articles of association, directors are elected at a general meeting of our
shareholders by a vote of the holders of a majority of the voting power represented at the
meeting. Additional directors may be elected between general meetings by a majority of our
directors. Our board is comprised of 10 persons, of which 3 have been determined to be
independent within the meaning of the applicable NASDAQ requirements. Two of these
independent directors also serve as outside directors mandated under Israeli law and
subject to additional criteria to help ensure their independence. See Outside
Directors, below. Each director, except for the outside directors, holds office
until the next annual general meeting of shareholders. Officers are appointed by our board
of directors.

Our
board of directors has appointed a compensation committee, comprised of Messrs. Gad
Goldstein, Dan Goldstein, Shai Beilis and Amira Berkovitz-Amir. The compensation committee
is responsible for granting options to employees and setting the compensation of our
executive officers.

Companies
trading on The NASDAQ Stock Market are generally required to have a majority of their
board members be independent. We are exempt from this requirement under the
controlled company exemption because more than 50% of our voting power is held
by Formula.

Outside Directors

Under
the Companies Law, 1999, referred to as the Companies Law, companies incorporated under
the laws of Israel whose shares have been offered to the public in or outside of Israel,
are required to appoint at least two outside directors. The Companies Law provides that a
person may not be appointed as an outside director if the person or the persons
relative, partner, employer or any entity under the persons control, has, as of the
date of the persons appointment to serve as outside director, or had, during the two
years preceding that date, any affiliation with the company or any entity controlling,
controlled by or under common control with the company. The term affiliation
includes:

| |  | an
employment relationship;
| | - | ---------------------------

| |  | a
business or professional relationship maintained on a regular basis;
| | - | ----------------------------------------------------------------------

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| |  | control;
and
| | - | ------------

| |  | service
as an office holder.
| | - | ----------------------------

No
person may serve as an outside director if the persons position or other business
activities create, or may create a conflict of interest with the persons
responsibilities as an outside director or may otherwise interfere with the persons
ability to serve as an outside director or if the person is an employee of the Israel
Securities Authority or of an Israeli stock exchange. If, at the time of election of an
outside director, all other directors are of the same gender, the outside director to be
elected must be of the other gender. Outside directors are elected by a majority vote at a
shareholders meeting, provided that either:

| | (1) | the
majority of shares voted at the meeting, including at least one-third of           the
shares of non-controlling shareholders or their representatives voted at the
          meeting, vote in favor of election; or
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (2) | the
total number of shares of non-controlling shareholders voted against the
               election of the outside director does not exceed one percent of the
aggregate                voting rights in the company.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Pursuant
to the Companies Law, all outside directors must have financial and accounting expertise
or professional qualifications, and at least one outside director must have financial and
accounting expertise. The terms financial and accounting expertise and
professional qualifications have been defined in regulations promulgated under
the Companies Law.

The
initial term of an outside director is three years and may be extended for an additional
three years. At present, Mr. Michael Chill and Ms. Amira Berkovitz-Amir serve as our
outside directors, Mr. Chill to hold office until July 2009 and Ms. Berkovitz-Amir until
December 2007.

Each
committee exercising the powers of the board of directors is required to include at least
one outside director. However, the audit committee should include all the outside
directors.

An
outside director is entitled to compensation as provided in regulations promulgated under
the Companies Law and is otherwise prohibited from receiving any compensation, directly or
indirectly, in connection with services provided as an outside director. We compensate our
two outside directors in accordance with regulations promulgated under the Companies Law.

Qualifications of Other
Directors

Under
the Companies Law, the board of directors of a publicly traded company is required to make
a determination as to the minimum number of directors who must have financial and
accounting expertise according to criteria that is defined in regulations promulgated
under the Companies Law effective as of January 2006. In accordance with the Companies
Law, the determination of the board should be based on, among other things, the type of
the company, its size, the volume and complexity of its activities and the number of
directors. Based on the foregoing considerations, our board determined that the number of
directors with financial and accounting expertise in our company shall not be less than
two.

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# Audit Committee

The
Companies Law requires public companies to appoint an audit committee, comprised of at
least three directors, including all of the outside directors. The chairman of the board
of directors, any director employed by or otherwise providing services to the company, and
a controlling shareholder or any relative of a controlling shareholder, may not be a
member of the audit committee.

In
addition, under applicable NASDAQ rules, we are currently required to have at least three
independent directors and to maintain an audit committee, whose members are independent of
management. Our outside directors qualify as independent directors under the applicable
NASDAQ rules and those of the Securities and Exchange Commission. We have established an
audit committee, consisting of our two outside directors, Mr. Michael Chill and Ms. Amira
Berkovitz-Amir, as well as Mr. Gur Shomron. The board has determined that both Michael
Chill and Amira Berkovitz-Amir are audit committee financial experts as
defined by applicable SEC regulations.

Under
the Companies Law, the audit committee is responsible for overseeing the business
management practices of the company in consultation with the companys internal
auditor and the independent auditor, making recommendations to the board to improve such
practices and approving related party transactions as required by the Companies Law. In
accordance with the Sarbanes-Oxley Act and NASDAQ requirements, our audit committee is
directly responsible for the appointment, compensation and oversight of our independent
auditors. In addition, the audit committee is responsible for assisting the board in
monitoring our financial statements and the effectiveness of our internal controls. We
have adopted a formal audit committee charter that we have implemented, embodying these
responsibilities.

Internal Auditor

Under
the Companies Law, the board of directors appoints an internal auditor, nominated by the
audit committee. The role of the internal auditor is to examine, among other matters,
whether the companys actions comply with the law and orderly business procedure.
Under the Companies Law, the internal auditor may be an employee of the company but not an
office holder, or an interested party (defined as a holder of 5% or more of the voting
rights in the company or of the issued share capital, the chief executive officer of the
company or any of its directors, or a person who has the authority to appoint the
companys chief executive officer or any of its directors), or a relative of an
office holder or of an interested party. In addition, the companys independent
accountant or its representative may not serve as the companys internal auditor.

65

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Approval of Certain
Transactions under the Companies Law

The
Companies Law codifies the fiduciary duties that office holders, including
directors and executive officers, owe to a company. An office holders fiduciary
duties consist of a duty of care and a duty of loyalty. The duty of loyalty includes (i)
avoiding any conflict of interest between the office holders position in the company
and his personal affairs, (ii) avoiding any competition with the company, (iii) avoiding
exploiting any business opportunity of the company in order to receive personal advantage
for himself or others and (iv) revealing to the company any information or documents
relating to the companys affairs that the office holder has received due to his
position as an office holder. Each person listed in the table under Directors and
Senior Management above is an office holder. Under the Companies Law, arrangements
regarding the compensation of directors require the approval of the audit committee, the
board of directors and shareholder approval.

The
Companies Law requires that an office holder of a company promptly disclose any personal
interest that he or she may have and all related material information known to him or her,
in connection with any existing or proposed transaction by the company. In addition, if
the transaction is an extraordinary transaction as defined under the Companies
Law, the office holder must also disclose any personal interest held by the office
holders spouse, siblings, parents, grandparents, descendants, spouses
descendants and the spouses of any of the foregoing. In addition, the office holder must
also disclose any interest held by any corporation in which the office holder owns 5% or
more of the share capital, is a director or general manager or in which he or she has the
right to appoint at least one director or the general manager. An extraordinary
transaction is defined as a transaction other than in the ordinary course of
business, otherwise than on market terms or that is likely to have a material impact on
the companys profitability, assets or liabilities.

Under
the Companies Law, after the office holder complies with the disclosure requirements
described above, only board approval is required for any transaction that is not an
extraordinary transaction, unless the articles of association of the company provide
otherwise, and provided the transaction is not adverse to the companys interest. If
the transaction is an extraordinary transaction, the company must receive any approval
stipulated by its articles of association, the approval of the audit committee and the
approval of the board of directors, as well as shareholder approval. An office holder who
has a personal interest in a matter that is considered at a meeting of the board of
directors or the audit committee may not be present at this meeting or vote on this matter
unless the majority of the board members or members of the audit committee, as applicable,
have a personal interest in such matter and in such case, the matter should also be
approved by the shareholders of the company.

The
Companies Law applies the same disclosure requirements to a controlling shareholder of a
public company, including a shareholder that holds 25% or more of the voting rights in the
company if no other shareholder owns more than 50% of the voting rights in the company.
Extraordinary transactions with a controlling shareholder or in which a controlling
shareholder has a personal interest, and the terms of compensation of a controlling
shareholder or its relative who is an office holder or an employee of the company, require
the approval of the audit committee, the board of directors and the shareholders of the
company. The shareholder approval must include at least one-third of the shareholders who
have no personal interest in the transaction and are voting on the subject matter or,
alternatively, the total shareholdings of those who have no personal interest in the
transaction who vote against the transaction must not represent more than one percent of
the voting rights in the company. In certain cases provided in regulations promulgated
under the Companies Law, shareholder approval is not required.

66

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The
approvals of the board of directors and shareholders are required for a private placement
of securities (or a series of related private placements during a 12-month period or that
are part of one continuous transaction or transactions conditioned upon each other) in
which:

| |  | the
securities issued represent at least 20% of the companys actual voting power prior
to the issuance of such securities, and such issuance increases the relative holdings of
a 5% shareholder or causes any person to become a 5% shareholder, and the consideration
in the transaction (or a portion thereof) is not in cash or in securities listed on a
recognized stock exchange, or is not at a fair market value; or
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | a
person would become, as a result of such transaction, a controlling shareholder of the
company.
| | - | -------------------------------------------------------------------------------------------------

Under
the Companies Law, a shareholder has a duty to act in good faith towards the company and
other shareholders and to refrain from abusing his power in the company including, among
other things, voting in a general meeting of shareholders on the following matters:

| |  | any
amendment to the articles of association;
| | - | ---------------------------------------------

| |  | an
increase of the company's authorized share capital;
| | - | ------------------------------------------------------

| |  | a
merger; or
| | - | ------------

| |  | approval
of interested party transactions that require shareholder approval.
| | - | ----------------------------------------------------------------------------

In
addition, any controlling shareholder, any shareholder who knowingly possesses power to
determine the outcome of a shareholder vote and any shareholder who, pursuant to the
provisions of a companys articles of association, has the power to appoint or
prevent the appointment of an office holder in the company, is under a duty to act with
fairness towards the company. The Companies Law does not describe the substance of this
duty.

For
information concerning personal interests of certain of our office holders and our
principal shareholders in certain transactions with us, see Item 7.B. Related Party
Transactions.

Exculpation, Insurance
and Indemnification of Directors and Officers

Under
the Companies Law, an Israeli company may not exempt an office holder from liability with
respect to a breach of his duty of loyalty, but may exempt in advance an office holder
from his liability to the company, in whole or in part, with respect to a breach of his
duty of care, provided, however, that such a breach is not related to a distribution of a
dividend or any other distribution by the company.

67

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Office
Holders Insurance

Our
articles of association provide that, subject to the provisions of the Companies Law, we
may enter into a contract for insurance of all or a part of the liability of any of our
office holders imposed on the office holder in respect of an act performed in his or her
capacity as an office holder, in respect of each of the following:

| |  | a
breach of his duty of care to us or to another person;
| | - | --------------------------------------------------------

| |  | a
breach of his duty of loyalty to us, provided that the office holder acted in good faith
and had reasonable cause to assume that such act would not prejudice our interests; or
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | a
financial obligation imposed on him or her in favor of another person.
| | - | ------------------------------------------------------------------------

Indemnification
of Office Holders

Our
articles of association provide that, subject to the provisions of the Companies Law, we
may indemnify our office holders in respect of an obligation or expense specified below
imposed on an office holder in respect of an act performed in his or her capacity as an
office holder, as follows:

a
financial obligation imposed on him or her in favor of another person by a court
judgment, including a compromise judgment or an arbitrators award approved by court;

reasonable
litigation expenses, including attorneys fees, incurred by the office holder as a
result of an investigation or proceeding instituted against the office holder by a
competent authority, provided that such investigation or proceeding concluded without the
filing of an indictment against the office holder; and either (a) concluded without the
imposition of any financial liability in lieu of a criminal proceeding; or (b) a
financial liability was imposed on him in lieu of a criminal proceeding for an offense
that does not require proof of criminal intent; and

reasonable
litigation expenses, including attorneys fees, expended by the office holder or
charged to the office holder by a court, in a proceeding instituted against the office
holder by the company or on its behalf or by another person, or in a criminal charge from
which the office holder was acquitted, or in a criminal proceeding in which the office
holder was convicted of an offense that does not require proof of criminal intent.

We
may undertake to indemnify an office holder as aforesaid, (a) prospectively, provided that
in respect of (i) above, the undertaking is limited to categories of events that in the
opinion of our board of directors are foreseeable in light of the companys
operations at the time that the undertaking to indemnify is given, and for an amount or
criteria that our board has determined as reasonable under the circumstances, and further
provided that that such events and amount or criteria are indicated in the indemnification
undertaking; and (b) retroactively.

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We
have entered into an undertaking to indemnify our office holders in specified limited
categories of events and in specified amounts, subject to the limitations set by the
Companies Law and our articles of association, as described above. For more information,
see Item 7.B. Related Party Transactions  Indemnification of Office
Holders.

Limitations
on Exemption, Insurance and Indemnification

The
Companies Law provides that a company may not indemnify an office holder, enter into an
insurance contract that would provide coverage for any monetary liability, or exempt an
office holder from liability, with respect to any of the following:

| |  | a
breach by the office holder of his duty of loyalty, except that the company may indemnify
or provide insurance coverage to the office holder if the office holder acted in good
faith and had a reasonable basis to believe that the act would not prejudice the company;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | a
breach by the office holder of his duty of care if the breach was done intentionally or
recklessly, except for a breach that was made in negligence;
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | any
act or omission done with the intent to derive an illegal personal benefit; or
| | - | ----------------------------------------------------------------------------------

| |  | any
fine levied against the office holder.
| | - | ------------------------------------------

In
addition, under the Companies Law, indemnification of, and procurement of insurance
coverage for, our office holders must be approved by our audit committee and our board of
directors and, in specified circumstances, by our shareholders.

We
have procured directors and officers liability insurance and obtained all
necessary approvals.

|D. | Employees
|-- | ---------

The
table below presents certain information regarding the number of our employees, the sector
in which they are employed and their geographical area of employment, in the periods
indicated.

|                                  | 2005 | 2004 | 2003
|--------------------------------- | ---- | ---- | ----
|
|
|
|
|Technical Experts                 |      |      |     
|Research and Development          |      |      |     
|Sales, General and Administrative |      |      |     
|                                  |      |      |     
|Total                             |      |      |     
|                                  |      |      |     
|                                  |      |     
|In Israel                         |      |      |     
|In Europe                         |      |      |     
|In the United States              |      |      |     

These
employees include expert consultants who we train for the implementation of our
modernization tools and methodologies.

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With
respect to our employees in Israel, we are subject to various Israeli labor laws and labor
practices, and to administrative orders extending certain provisions of collective
bargaining agreements between the Histadrut (Israels General Federation of Labor)
and the Coordinating Bureau of Economic Organizations (the Israeli federation of
employers organizations) to all private sector employees. For example, mandatory
cost of living adjustments, which compensate Israeli employees for a portion of the
increase in the Israeli consumer price index, are determined on a nationwide basis.
Israeli law also requires the payment of severance benefits upon the termination,
retirement or death of an employee. We meet this requirement by contributing on an ongoing
basis towards managers insurance funds that combine pension, insurance
and, if applicable, severance-pay benefits. In addition, Israeli employers and employees
are required to pay specified percentages of wages to the National Insurance Institute,
which is compatible with the United States Social Security Administration. Other
provisions of Israeli law and regulations govern matters such as the length of the
workday, minimum wages, other terms of employment and restrictions on discrimination. We
are also subject to the labor laws and regulations of other jurisdictions in the world
where we have employees.

|E. | Share
Ownership
|-- | ---------------

The
following presents information regarding the ownership of our ordinary shares by the
persons listed in the table under Directors and Senior Management, as of March
24, 2006. The percentage of outstanding ordinary shares is based on 13,842,079 ordinary
shares outstanding as of March 24, 2006 (excluding 1,647,594 shares held by two of our
wholly owned subsidiaries).

Unless
otherwise specifically indicated, the address of each of the persons set forth below is at
c/o BluePhoenix, 8 Maskit Street, Herzlia 46120.

|Name                          | Shares beneficially owned(1) | Options to purchase
ordinary shares
|----------------------------- | ---------------------------- | -----------------------------------
|
|
|
|
|Arie Kilman (2)               |                              |                                    
|                              |                              |                                    
|Dan Goldstein                 |                              |                                    
|                              |                              |                                    
|Gad Goldstein                 |                              |                                    
|                              |                              |                                    
|Aaron Crystal                 |                              |                                    
|                              |                              |                                    
|Shai Beilis                   |                              |                                    
|                              |                              |                                    
|Iris Yahal                    |                              |                                    
|                              |                              |                                    
|Naamit Salomon                |                              |                                    
|                              |                              |                                    
|Gur Shomron                   |                              |                                    
|                              |                              |                                    
|Michael Chill                 |                              |                                    
|                              |                              |                                    
|Amira Berkovitz-Amir          |                              |                                    
|                              |                              |                                    
|All directors and officers as |                              |                                    
|a group (10 persons) (3) (5)  |                              |                                    

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---

| | (1) | Each
of the directors and executive officers whose holdings are not separately
               specified in the above table beneficially owns less than one percent of
our                outstanding ordinary shares.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (2) | Mr.
Kilman was granted options to purchase ordinary shares under the following
               terms: (i) currently exercisable options to purchase 375,000 ordinary
shares at                $2.25 per share, which expire in April 2013; (ii) options to
purchase 200,000                ordinary shares exercisable at $4.00 per share, of which
171,667 are currently                exercisable. These options will expire in September
2013; and (iii) currently                exercisable options to purchase 150,000 ordinary
shares at $6.00 per share,                which expire in September 2015.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (3) | Includes
294 shares that Anat Crystal, Mr. Crystals spouse, beneficially
               owns.
| | --- | ----------------------------------------------------------------------------------------------

| | (4) | Mrs.
Yahal was granted options to purchase ordinary shares under the following
               terms: (i) currently exercisable options to purchase 15,000 ordinary
shares at                $6.50 per share, which expire in November 2006; (ii) currently
exercisable                options to purchase 10,000 ordinary shares exercisable at
$5.50 per share, which                expire in October 2010; (iii) currently exercisable
options to purchase 30,000                ordinary shares at $3.00 per share, which
expire in February 2012; (iv)                currently exercisable options to
purchase16,000 ordinary shares at $2.25 per                share, which expire in April
2013; (v) currently exercisable options to purchase                10,000 ordinary shares
at $4.50 per share, which expire in April 2013; (vi)                Option to purchase
15,000 ordinary shares exercisable at $3.50 per share, of                which 13,722 are
currently exercisable. These options will expire in September                2013; and
(vii) currently exercisable options to purchase 70,000 ordinary shares                at
$5.00 per share, which expire in December 2015.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (5) | Includes
currently exercisable options to purchase 872,685 ordinary shares, held                by
two of our directors who are also officers.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------

Arrangements Involving
the Issuance of BluePhoenixs Shares or Grant of Options to Purchase Shares

The
1996 Share Option Plan

In
1996, we adopted two option plans. One of these option plans has been terminated after all
options granted under it had been exercised.Pursuant to our other 1996 option
plan, as amended, we reserved 3,700,000 ordinary shares for issuance to our and our
subsidiaries directors, officers, consultants and employees. As of March 24, 2006,
options to purchase 2,758,167 ordinary shares were outstanding under the plan. The
exercise price of the options granted under the extant 1996 option plan ranges from $2.25
to $10.50.

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Our
board of directors administers our 1996 option plan. Under the 1996 option plan, as
amended, options to purchase our ordinary shares may be granted to our and our
subsidiaries directors, officers, consultants and employees. Our board of directors
is empowered, among other things, to designate the grantees, dates of grant, the exercise
price of the options and the terms of exercise of the options. Unless determined otherwise
by the board, the options generally vest over a three-year period. Unvested options are
forfeited shortly following termination of employment, unless otherwise agreed. Under the
1996 option plan, the grantee is responsible for all personal tax consequences of the
grant and the exercise of the options. Each option granted under the 1996 option plan is
exercisable during a term of ten years from the date of grant of the option. The 1996
option plan will expire on August 6, 2013, except as to options outstanding on that date.

In
anticipation of the effect of the adoption of Statement of Accounting Standard No. 123R,
or SFAS 123R, and under the management belief that in the currently increasing competition
in the labor market, an acceleration may have a positive effect on employee morale and
retention, our board of directors and compensation committee approved a of December 27,
2005, the acceleration of several outstanding unvested options under our 1996 option plan
so as to be fully-vested as of such date (see Notes 1T and 12B1 to our financial
statements). As a result, options to purchase 144,900 BluePhoenix ordinary shares and
options to purchase 1,228,997 shares of Mainsoft, were accelerated. However, the
acceleration of options held by our officers who also serve as directors of our company,
is subject to shareholder approval.

Options
Granted to Employees of One of Our Subsidiaries

In
connection with the purchase of a controlling interest in IntraComp Group Incorporated in
2000, we granted to certain employees of IntraComp options to purchase an aggregate of
43,000 of our ordinary shares. The options are exercisable at an exercise price of $9.625
per share and shall expire in August 2010.

|ITEM 7. | MAJOR
SHAREHOLDERS AND RELATED PARTY TRANSACTIONS
|------- | -------------------------------------------------

|A. | Major
Shareholders
|-- | ------------------

The
following table presents information regarding the ownership of our ordinary shares at
March 24, 2006 by each person known to us to be the beneficial owner of 5% or more of our
ordinary shares. Except where we indicated otherwise, we believe, based on information
furnished by these owners, that the beneficial owners of our shares listed below have sole
investment and voting power with respect to the shares.

|Name and Address            | Number | Percent (1)
|--------------------------- | ------ | -----------
|
|
|
|
|Formula Systems (1985) Ltd. |        |            
|                            |        |            
|Aaron Crystal               |        |            
|                            |        |            
|Arie Kilman                 |        |            

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---

| | (1) | Unless
otherwise indicated, percentages in the above table are based on           13,842,079
ordinary shares outstanding as of March 24, 2006, and do not include           1,647,594
ordinary shares that two of our subsidiaries hold. Pursuant to Israeli           law,
these shares do not confer upon our subsidiaries any voting rights           (although
such shares entitle their holders to participation rights upon           distribution).
In January 2006, we sold 136,000 shares held by one of our           subsidiaries to
Israeli institutional investors in Israel. In February 2006, we           sold 86,971
shares held by one of our subsidiaries to Outlook Systems Ltd. For           more
information about the sale of our shares to Outlook Systems, see Item
          4.B. Business Overview  Investments and Acquisitions  Outlook.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (2) | Formula
owns of record 8,033,026 ordinary shares constituting approximately           58.0% of
our outstanding ordinary shares. During 2003 through 2005, Formula           purchased
183,135 ordinary shares in the open market. Dan Goldstein, a member of           our
board of directors and chief executive officer and chairman of the board of
          Formula, owns 424,510 ordinary shares. Gad Goldstein, the chairman of our board
          of directors and a director and president of Formula, owns 330,628 ordinary
          shares. Messrs. Dan Goldstein and Gad Goldstein have entered into agreements,
          which require them to vote their ordinary shares as instructed by Formula. As a
          result of these voting agreements, Formula beneficially owns approximately
63.5%           of our outstanding shares. Dan Goldstein holds, through a wholly owned
company,           50% interest in FIMIGold LP, which owns 33% of the outstanding shares
of           Formula. Gad Goldstein owns 3.0% of the outstanding shares of Formula.
Messrs.           Dan and Gad Goldstein are brothers. Based on the foregoing, Dan
Goldstein and           Gad Goldstein each may be deemed to share with Formula the power
to vote and           dispose of our ordinary shares beneficially owned by Formula. Each
of Dan           Goldstein and Gad Goldstein disclaims beneficial ownership of the
ordinary           shares beneficially owned by Formula.
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (3) | Includes
294 shares that Anat Crystal, Mr. Crystals spouse, beneficially           owns.
During 2003 through 2005, Mr. Crystal sold 404,662 ordinary shares in the           open
market.
| | --- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (4) | Includes
currently exercisable options to purchase 707,963 ordinary shares. The
          percentage of holdings includes those options. In November 2002, as part of the
          share exchange transaction with Liraz, we issued to Arie Kilman, a former
          shareholder of Liraz, 625,183 of our ordinary shares. In 2003, Mr. Kilman sold
          33,369 ordinary shares in the open market, and in 2005, Mr. Kilman purchased
          17,385 ordinary shares in the open market.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (5) | Percentage
is calculated based on 14,550,042 ordinary shares outstanding, which           include
currently exercisable options to purchase 707,963 ordinary shares held           by Mr.
Kilman.
| | --- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

All
of our ordinary shares have equal voting rights. Under our two buy-back programs (as
described in Item 5.B. Liquidity and Capital Resources above), two of our
subsidiaries purchased 1,870,565 of our ordinary shares, of which 136,000 shares were sold
in January 2006 to Israeli institutional investors in Israel and 86,971 shares were sold
in February 2006 to Outlook Systems Ltd. Under applicable Israeli law, so long as the
shares are held by our subsidiaries, they have no voting rights but such shares confer
upon their holders participation rights upon distribution.

In
November 2002, we purchased through a share exchange transaction 86% of the outstanding
share capital of Liraz. As part of the transaction, we issued to Lirazs selling
shareholders, including Formula, 3,478,624 of our ordinary shares, constituting an
aggregate of 26% of our outstanding share capital. Of these shares, we issued to Formula
2,343,113 ordinary shares.

As
of December 1, 2005, there were 25 record holders of our ordinary shares. Of these record
holders, 17 holders had mailing addresses in the United States owning an aggregate of
approximately 19% of our outstanding ordinary shares, excluding the shares that our
subsidiaries hold. As of December 1, 2005, we had approximately 1,200 beneficial
shareholders.

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|B. | Related
Party Transactions
|-- | --------------------------

Management
Agreement with Formula

On
January 1, 1996, we signed a letter agreement with Argotec Ltd., at that time our
parent company wholly owned by Formula, pursuant to which Formula provides us with
administrative and management support. Under the agreement, Formula provides three of our
directors, including our chairman of the board, who is active in the direction of our
business. Additionally, Formula arranges to have certain volume discounts extended to us
as part of Formulas control group, and Formula provides us with administrative
services, including services relating to insurance, human resources, global planning, real
property leasing, and the department of motor vehicles.

Pursuant
to the letter agreement, we pay to Formula in return for its services, a management fee
equal to 3.0% of our revenues, up to a maximum of $180,000 per year. The amount of
management fee was negotiated between us and Argotec in 1996 when we initially entered
into the letter agreement. The amount of the fee was determined based primarily on the
parties good faith estimates of the value of services to be provided by the three
directors seconded to us by Formula and the extent of our expected cost savings to be
generated by Formulas assistance in obtaining volume discounts and the provision of
administrative support. Although we did not engage in actual negotiations with potential
third-party providers of comparable services, the fee was based in part on our market
knowledge of the cost of obtaining such services from third parties and/or developing the
internal resources necessary to carry out these functions ourselves.

We
pay the management fee to Formula in installments at the end of each quarter. For the year
ended December 31, 2005, a management fee of $180,000 was payable to Formula under this
agreement, representing 0.3% of our revenues in 2005. In addition, we reimburse Formula
from time to time for expenses Formula incurred on our behalf.

For
more information regarding the positions that some of our directors hold in Formula and
their holdings in Formulas shares, see Item 6.A. Directors and Senior
Management and Item 7.A. Major Shareholders.

Cooperation
with Matrix

We
have been cooperating with Matrix Ltd., a subsidiary of Formula, in performance of
modernization projects in Israel and license agreements. In 2005, revenues from sales
through Matrix amounted to $1.7 million.

Matrix
also serves as a subcontractor in several projects we perform. In 2005, the aggregate
expense to Matrix subcontractors was $1.8 million.

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Registration
Rights Agreements, Voting Agreements

In
1997, we entered into a registration rights agreement with Formula, Dan Goldstein,
Gad Goldstein, Aaron Crystal and an additional shareholder, referred to collectively as
the holders. Under this registration rights agreement, the holders have certain
registration rights with respect to their ordinary shares. We have agreed that, beginning
January 31, 1998, at the request of the holders of a majority of the shares held by the
persons and entities who signed the agreement, and on no more than two occasions, we will
file a registration statement under the Securities Act for an offering of their shares
with respect to which registration is requested. In addition, if we otherwise propose to
register our ordinary shares under the Securities Act, these holders may request that we
register their shares as well, subject to certain limitations. We shall bear all fees and
expenses in connection with the registration, except that the holders will pay all fees
and expenses of their own counsel and all underwriting discounts and commissions relating
to their shares. As of March 24, 2006, the holders did not exercise their rights pursuant
to the agreement.

In
October 2002, we granted certain registration rights to Formula, Mr. Arie Kilman and other
shareholder of Liraz in the Share Exchange Agreement with those shareholders. Under this
agreement, if we propose to register our ordinary shares under the Securities Act, each of
these holders may request that we register their shares as well, subject to certain
limitations. We shall bear all expenses in connection with the registration, provided that
all underwriting commissions shall be paid by the holders selling shares with respect to
their shares sold.

In
May 2004, our board of directors approved to include 400,000 BluePhoenixs shares
held by certain directors and officers in a registration statement filed by us on June 1,
2004 and declared effective on March 15, 2005.

Messrs.
          Dan Goldstein and Gad Goldstein have entered into voting agreements that
require           them to vote their ordinary shares as instructed by Formula.

Transactions
Between Us and Our Subsidiaries

We
currently hold 40% of the outstanding share capital of MultiConn Technologies and have an
option to increase our holdings in MultiConn Technologies to 60%. As of March 24, 2006, we
lent to MultiConn Technologies an aggregate amount of $2.4 million. For more information
about M.S.I. MultiConn and MultiConn Technologies, see Item 4.B. Business Overview
 Investments and Acquisitions  MultiConn.

In
the fourth quarter of 2003, we exercised an option to purchase from Intercomp certain
technology for an aggregate of $1.9 million. In addition, we undertook to pay to Intercomp
royalties of 25% of the revenues generated from the purchased technology. In connection
with the purchase of Intercomps technology, we assumed the rights and obligations of
Intercomp under a distribution agreement, pursuant to which Intercomp granted rights to a
distributor to further develop and distribute Intercomps products. As of December
31, 2005, we lent to Intercomp an aggregate of approximately $2 million. The principal of
the loans plus interest accrued are convertible into preferred shares of Intercomp,
subject to certain conditions. For more information about Intercomp, see Item 4.B.
Business Overview  Investments and Acquisitions  Intercomp.

75

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In
2000, we entered into a management agreement with Mainsoft, under which we provide
Mainsoft with management and advisory consulting services. Until the end of 2005, Mainsoft
paid us in exchange for our services aggregate consideration of $120,000 per year. From
the beginning of 2006, the management fees were reduced to $60,000 per year.

|In
February 2005, we entered into an alliance agreement with Zulu for cooperation in
marketing and selling Zulus and our software tools and services. For more
information about Zulu, see Item 4.B. Business Overview  Investments and
Acquisitions  Zulu.
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Transactions
Between Us and Our Chief Executive Officer

Mr.
          Kilman, in his former position as Lirazs chairman of the board of
          directors, was granted by Liraz in May 2002 a loan in an amount equal to
          approximately $300,000. As of March 24, 2006, Mr. Kilman repaid $225,000 of the
          principal amount of the loan plus linkage differentials and accrued interest.
          For more information relating to the loan granted to Mr. Kilman, see Item
          6.B. Compensation.

Indemnification
of Office Holders

Since
July 2003, we grant to our office holders indemnification letters covering acts
performed in their capacity as office holders or employees of our company. On December 27,
2005, our shareholders approved an amendment to those indemnification letters, following a
recent amendment to the Companies Law, 1999. Pursuant to the new indemnification letters,
we undertake to indemnify each office holder to the maximum extent permitted by law in
respect of the following for any act or omission taken or made by the office holder in his
or her capacity as an office holder of our company:

| |  | any
financial obligation imposed on the office holder in favor of another person by a court
judgment, including a settlement or an arbitrators award approved by court,
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | all
reasonable litigation expenses, including attorneys fees, expended by the office
holder as a result of an investigation or proceeding instituted against the office holder
by a competent authority, provided that such investigation or proceeding concluded
without the filing of an indictment against the office holder and either (a) concluded
without the imposition of any financial liability in lieu of criminal proceedings; or (b)
concluded with the imposition of a financial liability in lieu of criminal proceeding but
relates to a criminal offense that does not require proof of mens rea(criminal
intent); and
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | all
reasonable litigation expenses, including attorneys fees, expended by the office
holder or charged to him or her by a court in a proceeding instituted against the office
holder by us or on our behalf or by another person, or in any criminal proceedings in
which the office holder is acquitted, or in any criminal proceedings of a crime that does
not require proof of mens rea (criminal intent) in which the office holder is
convicted.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

76

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The
indemnification also applies to any action taken by the office holder in respect of an act
performed in his or her capacity as an office holder or an employee of one of our
subsidiaries or as a director or observer at board of directors meetings of one of
our affiliates. Our undertaking for indemnification is limited to up to 25% of our
shareholders equity at the time of the claim for indemnification.

Our
undertaking for indemnification does not apply to a liability incurred as a result of any
of the following:

| |  | a
breach by the office holder of his or her duty of loyalty, unless, to the extent
permitted by law, the office holder acted in good faith and had reasonable cause to
assume that such act would not prejudice the interests of our company;
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | a
willful breach by the office holder of his or her duty of care, unless such breach was
solely due to               negligence;
| | - | --------------------------------------------------------------------------------------------------------------------------------

| |  | an
action taken or not taken with the intent of unlawfully realizing personal gain;
| | - | -----------------------------------------------------------------------------------

| |  | a
fine or penalty imposed on the office holder for an offense; and
| | - | ------------------------------------------------------------------

| |  | a
counterclaim made by us in connection with a claim against us filed by the office holder.
| | - | -------------------------------------------------------------------------------------------

Our
undertaking for indemnification is limited to such events specified in the indemnification
letter and determined by our board of directors to be foreseeable in light of the
companys operations.

Under
the indemnification letters, we exempt our office holders to the fullest extent permitted
by law, from liability for damages caused as a result of a breach by the office holder of
his or her duty of care to the company.

Office
Holders Insurance

We
have obtained an insurance policy covering our directors and officers
liability. Our subsidiaries participate in the premium payments of the insurance, on a
proportional basis. The total premium we paid during 2005 was approximately $68,000.

|C. | Interests
of Expert and Counsel
|-- | -------------------------------

Not applicable.

77

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|ITEM 8. | FINANCIAL
INFORMATION
|------- | ---------------------

|A. | Consolidated
Statements and Other Financial Information
|-- | -------------------------------------------------------

Financial Statements

The
financial statements required by this item are found at the end of this annual report,
beginning on page F-1.

Legal Proceedings

We
are not involved in any proceedings in which any of our directors, members of our senior
management or any of our affiliates is either a party adverse to us or to our subsidiaries
or has a material interest adverse to us or to our subsidiaries. We are also not involved
in any material legal proceedings, except as described below.

In
July 2003, a former Liraz shareholder filed an application with the Tel Aviv, Jaffa
District Court to approve a claim filed by him against us, as a class action. The claim
relates to the acquisition of Liraz shares, which we completed in March 2003. The
shareholder alleges that the share price we paid to Lirazs shareholders in the
tender offer and in a subsequent mandatory purchase was lower than the fair price of Liraz
shares. The maximum amount of the claim is approximately $5.8 million in the aggregate.
Under Israeli law, the courts approval is required for the plaintiff to represent
all of the shareholders of Liraz who sold their shareholdings to us pursuant to the tender
offer and the mandatory acquisition. The plaintiff has applied for such approval in the
lawsuit. A preliminary hearing is scheduled for June 2006. Based on our analysis of the
statement of claim, including an evaluation of the fair value of the Liraz shares, and the
price paid for Liraz in a previous transaction immediately prior to the tender offer, we
believe that the allegations against us in this proceeding are without merit and we intend
to vigorously defend the claim and contest the allegations made therein.

Dividend policy

We
have never declared or paid dividends to our shareholders and we do not intend to pay
dividends in the future. We anticipate that we will retain all of our future earnings for
use in the expansion and operation of our business.

|B. | Significant
Changes
|-- | -------------------

Except
as otherwise disclosed in this annual report, there has been no material change in our
financial position since December 31, 2005.

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|ITEM 9. | THE
OFFER AND LISTING
|------- | ---------------------

|A. | Offer
and Listing Details
|-- | -------------------------

The
following table shows the high and low closing price for our ordinary shares on the NASDAQ
National Market for the periods indicated.

|Calendar Period          | Price Per Share
|------------------------ | ---------------
|
|
|
|
|2001                     |                
|2002                     |                
|2003                     |                
|2004                     |                
|First Quarter            |                
|Second Quarter           |                
|Third Quarter            |                
|Fourth Quarter           |                
|2005                     |                
|First Quarter            |                
|Second Quarter           |                
|Third Quarter            |                
|Fourth Quarter           |                
|September                |                
|October                  |                
|November                 |                
|December                 |                
|2006                     |                
|January                  |                
|February                 |                
|March (through March 24) |                

The
following table shows the high and low closing price for our ordinary shares on the TASE
for the periods indicated.

|Calendar Period       | Price Per Share
|--------------------- | ---------------
|
|
|
|
|2001(from January 21) |                
|2002                  |                
|2003                  |                
|2004                  |                
|First Quarter         |                
|Second Quarter        |                
|Third Quarter         |                
|Fourth Quarter        |                
|2005                  |                
|First Quarter         |                
|Second Quarter        |                
|Third Quarter         |                
|Fourth quarter        |                
|October               |                
|November              |                
|December              |                

79

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|Calendar Period          | Price Per note
|------------------------ | --------------
|
|
|
|
|2006                     |               
|January                  |               
|February                 |               
|March (through March 24) |               

The
following table shows the high and low closing price for our series A convertible notes on
the TASE for the periods indicated.

|Calendar Period             | Price Per note
|--------------------------- | --------------
|
|
|
|
|2006                        |               
|February (From February 12) |               
|March (through March 24)    |               

|B. | Plan
of Distribution
|-- | --------------------

Not applicable.

|C. | Markets
|-- | -------

Our
ordinary shares have been traded in the United States on the NASDAQ National Market since
our initial public offering on January 30, 1997 and were not publicly traded prior to
this date. The symbol on the NASDAQ National Market for our ordinary shares is BPHX. On
January 21, 2001, we listed our ordinary shares for trading on the TASE.

Our
series A convertible notes have been traded on the TASE since February 12, 2006.

Pursuant
to Marketplace Rule 4350(a) of NASDAQ, we received a permanent exemption from Marketplace
Rule 4350(b)(1)(A), which requires a company to distribute to its shareholders copies of
its annual report containing its audited financial statements. We follow the common
practice among TASE companies, and do not send our annual financial statements to
shareholders. A copy of our annual report on Form 20-F is posted on our website promptly
after it is filed with the SEC.

|D. | Selling
Shareholders
|-- | --------------------

Not applicable.

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|E. | Dilution
|-- | --------

Not applicable.

|F. | Expenses
of the Issue
|-- | ---------------------

Not applicable.

|ITEM 10. | ADDITIONAL
INFORMATION
|-------- | ----------------------

|A. | Share
Capital
|-- | -------------

Not applicable.

|B. | Memorandum
and Articles of Association
|-- | --------------------------------------

We
are registered with the Israeli Companies Register under the number 52-004306-8. Our
objects are specified in our memorandum of association. These objects include:

| |  | operating
within the field of informational and computer systems;
| | - | -----------------------------------------------------------------

| |  | providing
management, consulting and sale services for computers, computer equipment, software for
         computers and for information systems;
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------

| |  | the
business of systems analysis, systems programming and computer programming; and
| | - | -----------------------------------------------------------------------------------

| |  | establishing
facilities for instruction and training for computers and digital systems.
| | - | ---------------------------------------------------------------------------------------

Description of Our Share
Capital

Our
company share capital consists of ordinary shares. Our articles of association do not
restrict in any way the ownership of our ordinary shares by nonresidents, except that
these restrictions may exist with respect to citizens of countries that are in a state of
war with Israel.

Transfer of Shares

Fully
paid ordinary shares are issued in registered form and may be freely transferred under our
articles of association unless the transfer is restricted or prohibited by another
instrument.

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Modification of Class
Rights

Under
our articles of association, the rights attached to any class unless otherwise provided by
the terms of the class, including voting, rights to dividends and the like, may be varied
by adoption of the necessary amendment to the articles of association, provided that the
affected shareholders approve the change by a class meeting in which a simple majority of
the voting power of the class represented at the meeting and voting on the matter approves
the change.

Dividend Rights and
Liquidation Rights

We
may declare a dividend to be paid to the holders of ordinary shares according to their
rights and interests in our profits. We may pay the dividend as an allotment of shares or
a distribution of assets. If we do decide to issue dividends by an allotment of shares at
a price lower than the nominal value of those shares, we must convert a portion of our
profits or any other source of equity to share capital in an amount equal to the
difference between the nominal value of the shares and the price paid in the dividend. If
dividends remain unclaimed for seven years from the date we declared the dividend, they
lapse and revert back to us. In case of liquidation, after satisfying liabilities to
creditors, our assets will be distributed to the holders of ordinary shares in proportion
to their holdings. This right may be affected by the grant of a preferential dividend or
distribution rights to the holders of a class of shares with preferential rights that may
be authorized in the future.

Redemption provisions

In
accordance with our articles of association, we may issue redeemable shares and
accordingly redeem those shares. Our board may attach to redeemable shares the attributes
of shares, including voting rights and the right to participate in profits.

Voting, Shareholder
Meetings and Resolutions

Holders
of our ordinary shares have one vote for each ordinary share held on all matters submitted
to the vote of shareholders. These voting rights may be affected by the grant of any
special voting rights to the holders of a class of shares with preferential rights that
may be authorized in the future.

We
must hold an annual general meeting once a year with a maximum period of fifteen months
between the meetings. All other meetings of shareholders other than annual general
meetings are considered special general meetings. Our board of directors may, whenever it
decides it is appropriate, and shall, within 21 days after receiving a written demand from
one director or from one or more shareholders representing at least 10% of the outstanding
share capital and 1% of the voting power, call a special general meeting. The quorum
required for a general meeting of shareholders consists of two or more holders present in
person or by proxy who hold or represent at least 35% of the voting power. A meeting
adjourned for a lack of a quorum generally is adjourned to the same day in the following
week at the same time and place or to another later time if such time is specified in the
original notice convening the general meeting or if we give notice to the shareholders of
another time at least 72 hours before the date fixed for the adjourned meeting. At the
reconvened meeting, if a quorum is not present within half an hour from the time appointed
for holding the meeting, the required quorum will consist of two shareholders present in
person or by proxy.

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Under
the Companies Law, unless otherwise provided in the articles of association or applicable
law, all resolutions of the shareholders require a simple majority, except in certain
circumstances provided for under the Companies Law, which require a majority of at least
75% of the shares present at the meeting. In accordance with the Companies Law, all
shareholders meetings require prior notice of at least 21 days.

Under
the Companies Law, a shareholder has a duty to act in good faith towards the company in
which he holds shares and towards other shareholders and to refrain from abusing his power
in the company including voting in the general meeting of shareholders on:

| |  | any
amendment to the articles of association;
| | - | ---------------------------------------------

| |  | an
increase of the company's authorized share capital;
| | - | ------------------------------------------------------

| |  | a
merger; or
| | - | ------------

| |  | approval
of some of the acts and transactions that require shareholder approval.
| | - | --------------------------------------------------------------------------------

A
shareholder has the general duty to refrain from depriving rights of other shareholders.
Any controlling shareholder, any shareholder who knows that it possesses the power to
determine the outcome of a shareholder vote and any shareholder that, under the provisions
of the articles of association, has the power to appoint an office holder in the company,
is under a duty to act in fairness towards the company. The Companies Law does not
describe the substance of this duty.

Election of Directors

Our
ordinary shares do not have cumulative voting rights in the election of directors. As a
result, the holders of ordinary shares that represent more than 50% of the voting power
represented at a shareholders meeting have the power to elect all of our directors, other
than the outside directors that are appointed by a special majority of shareholders. For a
summary of those provisions in our articles of association with respect to the directors,
see Item 6. Directors, Senior Management, and Employees.

Anti-Takeover Provisions;
Mergers and Acquisitions under Israeli Law

Mergers

The
Companies Law includes provisions that allow a merger transaction and requires that each
company that is party to a merger approve the transaction by its board of directors and a
vote of the majority of its shares voting on the proposed merger at a shareholders
meeting called on at least 21 days prior notice. In determining whether a majority
has approved the merger, shares held by the other party to the merger or any person
holding at least 25% of the other party to the merger are excluded from the vote. The
Companies Law does not require court approval of a merger other than in specified
situations. Upon the request of a creditor of either party to the proposed merger, the
court may delay or prevent the merger if it concludes that there exists a reasonable
concern that as a result of the merger, the surviving company will be unable to satisfy
the obligations of any of the parties to the merger. In addition, a merger may not be
completed unless at least 70 days have passed from the time that a proposal for approval
of the merger has been filed with the Israeli registrar of companies.

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Tender
Offers

The
Companies Law also provides that an acquisition of shares of a public company on the open
market must be made by means of a tender offer if as a result of the acquisition the
purchaser would become a 25% shareholder of the company. The rule does not apply if there
is already another 25% shareholder of the company. Similarly, the Companies Law provides
that an acquisition of shares in a public company must be made by means of a tender offer
if, as a result of the acquisition, the purchaser would become a 45% shareholder, unless
there is a 50% shareholder of the company. These rules do not apply if the acquisition is
made by way of a merger as opposed to a tender offer. Regulations adopted under the
Companies Law provide that these tender offer requirements do not apply to companies whose
shares are listed for trading outside of Israel if, according to the law in the country in
which the shares are traded, including the rules and regulations of the stock exchange on
which the shares are traded, there is either a limitation on acquisition of any level of
control of the company, or the acquisition of any level of control requires the purchaser
to do so by means of a tender offer to the public. The Companies Law also provides that if
following any acquisition of shares, the acquirer holds 90% or more of the companys
shares or of a class of shares, the acquisition must be made by means of a tender offer
for all the target companys shares or all the shares of the class, as applicable. An
acquirer who wishes to eliminate all minority shareholders must do so by way of a tender
offer and acquire 95% of all shares not held by or for the benefit of the acquirer before
the acquisition. If, however, the tender offer to acquire 95% is not successful, the
acquirer may not acquire shares tendered if by doing so the acquirer would own more than
90% of the shares of the target company.

|C. | Material
Contracts
|-- | ------------------

We
consider the agreements related to the $5 million private placements of convertible
debentures and warrants completed in March 2004, the series A convertible notes in an
aggregate principal amount of $11.5 million, the acquisition of Lirazs shares and
our investments in Mainsoft Corporation as material contracts. For a summary of the terms
of these investments, see Item 4.B. Business Overview  Investments and
Acquisitions and Item 5.B. Liquidity and Capital Resources. In addition,
the agreements with Microsoft and SDC Udvikling described below are material to our
business.

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Licensing
Agreement with Microsoft

In
August 1998, we entered into a Windows source code license agreement with Microsoft that
terminated and superseded our prior arrangement with Microsoft. In May 2002, the parties
entered into an amendment to the license agreement that expanded our access to certain
Microsoft development technologies. Under the terms of the agreement, as amended, we
continue to have access to specified software code and documentation for specified
versions of Windows, Windows NT, and Windows XP, collectively referred to as the licensed
software. The agreement grants us the right to distribute the licensed software as a
component of our Visual MainWin® development kit and runtime products. The agreement
provides for the payment of royalties to Microsoft that are based upon the licensing of
our Visual MainWin® products, which include the licensed software. The agreement has a
perpetual term although it may be terminated earlier under certain circumstances,
including in the event of change of control of either of the parties. In addition, the
agreement provides that in the event that we cease the active distribution or licensing of
our Visual MainWin® products for more than one year, we will be deemed to have granted
to Microsoft a worldwide, exclusive, perpetual, irrevocable, royalty-free license to our
Visual MainWin® products.

The
agreement sets out the procedure under which Microsoft may waive the payment of certain
royalties by us relating to specific customers. Upon recording revenue from a customer, we
accrue the royalties due to Microsoft in product cost of revenues and often apply for a
waiver. We recognize a reduction in product cost of revenues when a waiver is approved by
Microsoft.

In
December 2003, we entered into an independent contractor agreement with Microsoft. In
accordance with this agreement, Microsoft agreed to offset the value of the services we
performed under the independent contractor agreement from accrued royalties of up to
$1,605,000. During the year ended December 31, 2005, we accrued royalties due to Microsoft
of $485,000, and recognized credits (reductions to expense) related to waivers and to
services performed of $18,000 and $52,000, respectively.

Our
ability to develop, sell and market our Visual MainWin® products that use the licensed
software is dependent upon the continued access to the licensed software and updated
additional source code. While we believe that our relationship with Microsoft will
continue on terms acceptable to us, a change in or termination of the agreement could
prevent us from developing and selling certain products and materially adversely affect
our business, results of operations and financial condition.

Services
Agreement with SDC Udvikling

In
October 2002, we entered into a services agreement with an affiliated company of SDC,
named SDC Udvikling A/S, for the provision of IT development services related to our tool,
AppBuilder. Under the agreement, SDC Udvikling has been purchasing from us various
services pursuant to specific amendments to the agreement and purchase orders signed from
time to time. SDC Udvikling accounted for 17% and 15% of our revenues in 2005 and 2004.

85

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|D. | Exchange
Controls
|-- | -----------------

Under
current Israeli regulations, we may pay dividends or other distributions in respect of our
ordinary shares either in non-Israeli or Israeli currencies. If we make these payments in
Israeli currency, they will be freely transferred in non-Israeli currencies at the rate of
exchange prevailing at the time of conversion. Because exchange rates between the NIS and
the dollar fluctuate continuously, a U.S. shareholder will be subject to the risk of
currency fluctuations between the date when we declare NIS-denominated dividends and the
date when we pay them in NIS. See Item 3.D. Risk Factors.

Nonresidents
of Israel may freely hold and trade our securities pursuant to the general permit issued
under the Israeli Currency Control Law, 1978. Neither our memorandum of association nor
the laws of the State of Israel restrict in any way the ownership of our ordinary shares
by nonresidents, except that these restrictions may exist with respect to citizens of
countries that are in a state of war with Israel.

|E. | Taxation
|-- | --------

Israeli Taxation

The
following is a description of material tax consequences regarding the ownership and
disposition of the Companys ordinary shares under Israeli tax laws to which U.S. and
other non-Israeli shareholders may be subject. The information below does not apply to
specified persons or cover specified situations. Therefore, you are advised to consult
your own tax advisor as to particular tax consequences unique to you related to an
investment in our ordinary shares including the effects of applicable Israeli or foreign
or other tax laws and possible changes in the tax laws.

To
the extent that the discussion is based on legislation yet to be judicially or
administratively interpreted, we cannot assure you that the views we express herein will
accord with any such interpretation in the future.

Tax
Consequences Regarding Disposition of Our Ordinary Shares

In
general, Israel imposes capital gains tax on the sale of capital assets, including shares
of Israeli companies by both Israeli residents and non-Israeli resident shareholders,
unless a specific exemption is available or unless a tax treaty between Israel and the
shareholders country of residence provide otherwise. Shareholders that are not
Israeli residents are generally exempt from Israeli capital gains tax on any gain derived
from the sale of our ordinary shares, provided that (i) such shareholders did not
acquire the shares prior to our initial public offering; and (ii) such gains did not
derive from a permanent establishment of such shareholders in Israel. However, non-Israeli
corporations will not be entitled to the foregoing exemption if an Israeli resident
(a) has a controlling interest of 25% or more in such non-Israeli corporation; or
(b) is the beneficiary of or is entitled to 25% or more of the revenues or profits of
such non-Israeli corporation, whether directly or indirectly.

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In
certain instances where our non-Israeli shareholders may be liable to Israeli tax on the
sale of our ordinary shares, the payment of the consideration may be subject to Israeli
withholding tax.

In
addition, in the case when the sale, exchange or disposition of our ordinary shares by
shareholders who are U.S. residents (within the meaning of the U.S.-Israel Tax
Treaty) holding the ordinary shares as a capital asset will be also exempt from Israeli
capital gains tax under the U.S.-Israel Tax Treaty, unless, either (i) the
shareholders hold, directly or indirectly, shares representing 10% or more of our voting
shares during any part of the 12-month period preceding such sale, exchange or
disposition; or (ii) the capital gains arising from such sale, exchange or
disposition are attributable to a permanent establishment of the shareholders located in
Israel. In such case, the shareholders would be subject to Israeli capital gain tax, to
the extent applicable, as mentioned above. However, under the U.S.-Israel Tax Treaty, the
U.S. resident would be permitted to claim a credit for such taxes against the
U.S. federal income tax imposed on the sale, exchange or disposition, subject to the
limitation in the U.S. law applicable to foreign tax credits. The U.S.-Israel Tax
Treaty does not relate to U.S. state or local taxes.

Taxes
Applicable to Dividends

Nonresidents
of Israel are generally subject to Israeli income tax on the receipt of dividends paid on
our ordinary shares at the rate of 20% or 15% for dividends or income generated by an
approved enterprise, which tax will be withheld at source, unless a different rate is
provided in a treaty between Israel and the shareholders country of residence.

However,
the tax rate on dividends paid to a substantial shareholder (which is someone
who alone, or together with another person, holds, directly or indirectly, at least 10% in
one or all of any of the means of control in the corporation) is 25%.

Under
Israeli tax law, a distribution of dividends from income attributable to an Approved
Enterprise will be subject to tax in Israel at the rate of 15%, which is withheld and paid
by the company paying the dividend, if the dividend is distributed during the benefits
period or within the following 12 years (but the 12-year limitation does not apply to a
Foreign Investors Company). Any distribution of dividends from income that is not
attributable to an Approved Enterprise after January 1, 2006, will be subject to tax in
Israel at the rate of 20%.

Under
the U.S.-Israel Tax Treaty, the maximum rate of tax withheld in Israel on dividends paid
to a holder of our ordinary shares who is a U.S. resident (within the meaning of the
U.S.-Israel Tax Treaty) is 25%. However, dividends paid from income derived from our
Approved Enterprise are subject to withholding at the rate of 15%, although we cannot
assure you that we will designate the profits that are being distributed in a way that
will reduce shareholders tax liability according to the U.S.-Israel Tax Treaty.
Furthermore, the maximum rate of withholding tax on dividends, not generated by our
Approved Enterprise, that are paid to a U.S. corporation holding 10% or more of our
outstanding voting capital during the part of the tax year that precedes the date of the
payment of the dividend and during the whole of its prior tax year, is 12.5%. This reduced
rate will not apply if more than 25% of our gross income consists of interest or
dividends, other than dividends or interest received from a subsidiary corporation 50% or
more of the outstanding shares of the voting shares of which are owned by the company.

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A
nonresident of Israel who receives dividends with respect of which tax was fully paid, is
generally exempt from the duty to file returns in Israel in respect of such income,
provided such income was not derived from a business conducted in Israel by the taxpayer,
and the taxpayer has no other taxable sources of income in Israel.

United States Federal
Income Tax Considerations

Subject
to the limitations described herein, this discussion summarizes the material U.S. federal
income tax consequences of the purchase, ownership and disposition of our ordinary shares
to a U.S. holder. A U.S. holder is a holder of our ordinary shares who is:

| |  | an
individual citizen or resident of the U.S. for U.S. federal income tax purposes;
| | - | -----------------------------------------------------------------------------------

| |  | a
corporation or partnership (or another entity taxable as a corporation or partnership for
U.S. federal                   income tax purposes) created or organized under the laws
of the United States or any                   political subdivision thereof;
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | an
estate, the income of which is subject to U.S. federal income tax regardless of its
source; or
| | - | -------------------------------------------------------------------------------------------------

| |  | a
trust (i) if, in general, a U.S. court is able to exercise primary supervision over its
administration                   and one or more U.S. persons have the authority to
control all of its substantial                   decisions or (ii) that has in effect a
valid election under applicable U.S. Treasury                   regulations to be treated
as a U.S. person.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Unless
otherwise specifically indicated, this discussion does not consider the U.S. tax
consequences to a person that is not a U.S. holder and considers only U.S. holders that
will own the ordinary shares as capital assets.

This
discussion is based on current provisions of the Internal Revenue Code of 1986, as
amended, referred to as the Code, current and proposed Treasury regulations promulgated
under the Code and administrative and judicial interpretations of the Code, all as
currently in effect and all of which are subject to change, possibly with a retroactive
effect. This discussion does not address all aspects of U.S. federal income taxation that
may be relevant to any particular U.S. holder based on the U.S. holders individual
circumstances. In particular, this discussion does not address the U.S. federal income tax
consequences to U.S. holders who are broker-dealers or who own, directly, indirectly or
constructively, 10% or more of our outstanding voting shares, U.S. holders holding the
ordinary shares as part of a hedging, straddle or conversion transaction, U.S. holders
whose functional currency is not the U.S. dollar, insurance companies, tax-exempt
organizations, financial institutions, persons who acquired their shares upon the exercise
of employee stock options or otherwise as compensation, and persons subject to the
alternative minimum tax, who may be subject to special rules not discussed below.
Additionally, the tax treatment of persons who are, or hold the ordinary shares through, a
partnership or other pass-through entity is not considered, nor is the possible
application of U.S. federal estate or gift taxes or any aspect of state, local or non-U.S.
tax laws.

88

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You
are advised to consult your tax advisor with respect to the specific U.S. federal, state,
local and foreign income tax consequences to you of purchasing, holding or disposing of
our ordinary shares.

Taxation
of Distributions on the Ordinary Shares

We
have never paid dividends, and currently do not intend to pay dividends in the future. If we make
distributions in the future, the amount of the distribution with respect to the ordinary shares will equal the
amount of cash and the fair market value of any property distributed and will also include the amount of any
Israeli taxes withheld as described above under Taxation  Israeli Taxation. Subject to the discussion below
under Tax Consequences if We are a Passive Foreign Investment Company, a distribution paid by us with respect
to our ordinary shares to a U.S. holder will be treated as dividend income to the extent that the distribution
does not exceed our current and accumulated earnings and profits, as determined for U.S. federal income tax
purposes. Dividends that are received by U.S. holders that are individuals, estates or trusts will be taxed at
the rate applicable to long-term capital gains (a maximum rate of 15%), provided that such dividends meet the
requirements of qualified dividend income. Dividends that fail to meet such requirements, and dividends
received by corporate U.S. holders, are taxed at ordinary income rates. No dividend received by a U.S. holder
will be a qualified dividend (1) if the U.S. holder held the ordinary share with respect to which the dividend
was paid for less than 61 days during the 121-day period beginning on the date that is 60 days before the
exdividend date with respect to such dividend, excluding for this purpose, under the rules of Code section
246(c), any period during which the U.S. holder has an option to sell, is under a contractual obligation to sell,
has made and not closed a short sale of, is the grantor of a deep-in-the-money or otherwise nonqualified option
to buy, or has otherwise diminished its risk of loss by holding other positions with respect to, such ordinary
share (or substantially identical securities); or (2) to the extent that the U.S. holder is under an obligation
(pursuant to a short sale or otherwise) to make related payments with respect to positions in property
substantially similar or related to the ordinary share with respect to which the dividend is paid. If we were to
be a passive foreign investment company (as such term is defined in the Code) for any year, dividends paid on
our ordinary shares in such year or in the following year would not be qualified dividends. In addition, a
noncorporate U.S. holder will be able to take a qualified dividend into account in determining its deductible
investment interest (which is generally limited to its net investment income) only if it elects to do so; in such
case the dividend will be taxed at ordinary income rates.

The
amount of any distribution that exceeds the amount treated as a dividend will be treated
first as a nontaxable return of capital, reducing the U.S. holders tax basis in its
ordinary shares to the extent thereof, and then as capital gain from the deemed
disposition of the ordinary shares. Corporate holders will not be allowed a deduction for
dividends received in respect of the ordinary shares.

Dividends
paid by us in NIS will be included in the income of U.S. holders at the dollar amount of
the dividend (including any Israeli taxes withheld there from), based upon the spot rate
of exchange in effect on the date the distribution is included in income. U.S. holders
will have a tax basis in NIS for U.S. federal income tax purposes equal to that dollar
value. Any subsequent gain or loss in respect of NIS arising from exchange rate
fluctuations will generally be taxable as U.S. source ordinary income or loss.

89

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Subject
to the limitations set forth in the Code and the Treasury regulations there under, U.S. holders may elect
to claim as a foreign tax credit against their U.S. federal income tax liability the Israeli income tax withheld
from dividends received in respect of the ordinary shares. The limitations on claiming a foreign tax credit
include, among others, computation rules under which foreign tax credits allowable with respect to specific
classes of income cannot exceed the U.S. federal income taxes otherwise payable with respect to each such class
of income. In this regard, dividends paid by us will be foreign source passive income for U.S. foreign tax
credit purposes or, in the case of a financial services entity, financial services income. U.S. holders that do
not elect to claim a foreign tax credit may instead claim a deduction for the Israeli income tax withheld if they
itemize deductions. The rules relating to foreign tax credits are complex, and you should consult your tax
advisor to determine whether and to what extent you would be entitled to this credit. A U.S. holder will be
denied a foreign tax credit for Israeli income tax withheld from a dividend received on the ordinary shares (i)
if the U.S. holder has not held the ordinary shares for at least 16 days of the 31-day period beginning on the
date that is 15 days before the ex-dividend date with respect to such dividend or (ii) to the extent the U.S.
holder is under an obligation to make related payments with respect to positions in substantially similar or
related property. Any days during which a U.S. holder has substantially diminished its risk of loss on the
ordinary shares are not counted toward meeting the required 16-day holding period.

Taxation
on Disposition of the Ordinary Shares

Subject
to the discussion below under Tax Consequences if We are a Passive Foreign Investment Company, upon the
sale, exchange or other disposition of our ordinary shares, a U.S. holder will recognize capital gain or loss in
an amount equal to the difference between the amount realized on the disposition and the U.S. holders tax basis
in the ordinary shares. The gain or loss recognized on the disposition will be long-term capital gain or loss if
the U.S. holder held the ordinary shares for more than one year at the time of the disposition. Gain or loss
recognized by a U.S. holder on a sale, exchange or other disposition of ordinary shares generally  will be
treated as U.S. source income or loss for U.S. foreign tax credit purposes.

A U.S.
holder that uses the cash method of accounting calculates the dollar value of the proceeds received on the
sale as of the date that the sale settles. However, a U.S. holder that uses the accrual method of accounting is
required to calculate the value of the proceeds of the sale as of the trade date and may therefore realize
foreign currency gain or loss. A U.S. holder may avoid realizing foreign currency gain or loss by electing to use
the settlement date to determine the proceeds of sale for purposes of calculating the foreign currency gain or
loss. In addition, a U.S. holder that receives foreign currency upon the disposition of ordinary shares and
converts the foreign currency into dollars after the settlement date or trade date (whichever date the U.S.
holder is required to use to calculate the value of the proceeds of sale) will have foreign exchange gain or loss
based on any appreciation or depreciation in the value of the foreign currency against the dollar, which will
generally be U.S. source ordinary income or loss.

90

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Tax
Consequences If We Are a Passive Foreign Investment Company

We
will be a passive foreign investment company, or PFIC, for a taxable year if either (1)
75% or more of our gross income in the taxable year is passive income; or (2) 50% or more
of the value, determined on the basis of a quarterly average, of our assets in the
taxable year produce, or are held for the production of, passive income. If we own
(directly or indirectly) at least 25% by value of the stock of another corporation, we
will be treated for purposes of the foregoing tests as owning our proportionate share of
the other corporations assets and as directly earning our proportionate share of the
other corporations income. We believe that in 2005 we were not a PFIC and currently we
expect that we will not be a PFIC in 2006. However, PFIC status is determined as of the
end of the taxable year and is dependent on a number of factors, including the value of
our assets and the amount and type of our gross income. Therefore, there can be no
assurance that we will not become a PFIC for the current fiscal year ending December 31,
2006 or in a future year. We will notify U.S. holders in the event we conclude that we
will be treated as a PFIC for any taxable year.  If we are a PFIC, a U.S. holder must
determine under which of three alternative taxing regimes it wishes to be taxed:

| |  | The
QEF regime applies if the U.S. holder elects to treat us as a qualified
electing fund (QEF) for the first taxable year in which the U.S. holder
owns our ordinary shares or in which we are a PFIC, whichever is later, and if we comply
with certain reporting requirements. If the QEF regime applies, then each year that we
are a PFIC such U.S. holder will include in its gross income a proportionate share of our
ordinary earnings (which is taxed as ordinary income) and net capital gain (which is
taxed as long-term capital gain), subject to a separate election to defer payment of
taxes, which deferral is subject to an interest charge. These amounts would be included
in income by an electing U.S. holder for its taxable year in which our taxable year ends,
whether or not such amounts are actually distributed to the U.S. holder. A U.S. holders
basis in our ordinary shares for which a QEF election has been made would be increased to
reflect the amount of any taxed but undistributed income. Generally, a QEF election
allows an electing U.S. holder to treat any gain realized on the disposition of his
ordinary shares as capital gain.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Once
made, the QEF election applies to all subsequent taxable years of the U.S. holder in
which it holds our ordinary shares and for which we are a PFIC, and can be revoked only
with the consent of the Internal Revenue Service. The QEF election is made by attaching a
completed Internal Revenue Service Form 8621, including the PFIC annual information
statement, to a timely filed United States federal income tax return. Even if a QEF
election is not made, a U.S. person who is a shareholder in a PFIC must file a completed
Internal Revenue Service Form 8621 every year. If we believe we are or will become a
PFIC, we will determine whether we will comply with the reporting requirements that would
enable holders to make a QEF election. If a QEF election is made after the first taxable
year in which a U.S. holder holds our ordinary shares and we are a PFIC, then special
rules would apply.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

91

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| |  | A
second regime, the mark-to-market regime, may be elected so long as our
ordinary shares are marketable stock. Pursuant to this regime, an electing U.S. holders
ordinary shares are marked-to-market each year and the U.S. holder recognizes as ordinary
income or loss an amount equal to the difference as of the close of the taxable year
between the fair market value of our ordinary shares and the U.S. holders adjusted
tax basis therein. Losses are allowed only to the extent of net mark-to-market gain
previously included by the U.S. holder under the election for prior taxable years. An
electing U.S. holders adjusted basis in our ordinary shares is increased by income
recognized under the mark-to-market election and decreased by the deductions allowed
under the election.
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Under
the mark-to-market election, gain on the sale of our ordinary shares is treated as
ordinary income, and          loss on the sale of our ordinary shares, to the extent the
amount of loss does not exceed the net          mark-to-market gain previously included,
is treated as ordinary loss. The mark-to-market election          applies to the tax year
for which the election is made and all subsequent tax years, unless the ordinary
         shares cease to be marketable or the Internal Revenue Service consents to the
revocation of the election.          If the mark-to-market election is made after the
first taxable year in which a U.S. holder holds our          ordinary shares and we are a
PFIC, then special rules would apply.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |  | A
U.S. holder making neither the QEF election nor the mark-to-market election is subject to
the excess distribution regime. Under this regime, excess distributions are
subject to special tax rules. An excess distribution is either (1) a distribution with
respect to ordinary shares that is greater than 125% of the average distributions
received by the U.S. holder from us over the shorter of either the preceding three years
or such U.S. holders holding period for our ordinary shares, or (2) 100% of the
gain from the disposition of our ordinary shares (including gain deemed recognized if the
ordinary shares are used as security for a loan).
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | Excess
distributions must be allocated ratably to each day that a U.S. holder has held our
ordinary shares. A U.S. holder must include amounts allocated to the current taxable year
and to any period prior to the first day of the first taxable year for which we are a
PFIC in its gross income as ordinary income for the current taxable year. All amounts
allocated to other years of the U.S. holder would be taxed at the highest tax rate for
each such other year applicable to ordinary income. The U.S. holder also would be liable
for interest on the deferred tax liability for each such other year calculated as if such
liability had been due with respect to each such other year. A U.S. holder that is an
individual is not allowed a deduction for interest on the deferred tax liability. The
portions of distributions that are not characterized as excess distributionsare
subject to tax in the current year under the normal tax rules of the Code.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | A
U.S. person who inherits shares in a foreign corporation that was a PFIC in the hands of
the decedent (who did not make a QEF election described above), is denied the otherwise
available step-up in the tax basis of such shares to fair market value at the date of
death. The U.S. person steps into the shoes of the decedent and will be subject to the
rules described above.
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

92

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U.S.
          holders are urged to consult their tax advisors regarding the application of
the           PFIC rules, including eligibility for and the manner and advisability of
making,           the QEF election or the mark-to-market election.

Information
Reporting and Backup Withholding

A
U.S. holder generally is subject to information reporting and may be subject to backup withholding at a rate of
up to 28% with respect to dividend payments and receipt of the proceeds from the disposition of the ordinary
shares. Backup withholding will not apply with respect to payments made to exempt recipients, including
corporations and tax-exempt organizations, or if a U.S. holder provides correct taxpayer identification number
(or certifies that he has applied for a taxpayer identification number), certifies that such holder is not
subject to backup withholding or otherwise establishes an exemption. Backup withholding is not an additional tax
and may be claimed as a credit against the U.S. federal income tax liability of a U.S. holder, or alternatively,
the U.S. holder may be eligible for a refund of any excess amounts withheld under the backup withholding rules,
in either case, provided that the required information is furnished to the Internal Revenue Service.

Non-U.S.
holders of Ordinary Shares

Except
as provided below, a non-U.S. holder of ordinary shares (except certain former U.S.
citizens and long-term residents of the United States) will not be subject to U.S. federal
income or withholding tax on the receipt of dividends on, and the proceeds from the
disposition of, an ordinary share, unless that item is effectively connected with the
conduct by the non-U.S. holder of a trade or business in the United States and, in the
case of a resident of a country that has an income tax treaty with the United States, that
item is attributable to a permanent establishment in the United States or, in the case of
an individual, a fixed place of business in the United States. In addition, gain
recognized by an individual non-U.S. holder will be subject to tax in the United States if
the non-U.S. holder is present in the United States for 183 days or more in the taxable
year of the sale and other conditions are met.

Non-U.S.
          holders will not be subject to information reporting or backup withholding with
          respect to the payment of dividends on ordinary shares unless the payment is
          made through a paying agent, or an office of a paying agent, in the United
          States. Non-U.S. holders will be subject to information reporting and backup
          withholding at a rate of up to 28% with respect to the payment within the
United           States of dividends on the ordinary shares unless the holder provides
its           taxpayer identification number, certifies to its foreign status, or
otherwise           establishes an exemption.

Non-U.S.
          holders will be subject to information reporting and backup withholding at a
          rate of up to 28% on the receipt of the proceeds from the disposition of the
          ordinary shares to, or through, the United States office of a broker, whether
          domestic or foreign, unless the holder provides a taxpayer identification
          number, certifies to its foreign status or otherwise establishes an exemption.
          Non-U.S. holders will not be subject to information reporting or backup
          withholding with respect to the receipt of proceeds from the disposition of the
          ordinary shares by a foreign office of a broker; provided, however, that if the
          broker is a U.S. person or a U.S. related person, information
          reporting (but not backup withholding) will apply unless the broker has
          documentary evidence in its records of the non-U.S. holders foreign
status           or the non-U.S. holder certifies to its foreign status under penalties
of           perjury or otherwise establishes an exemption. For this purpose, a U.S.
          related person is a broker or other intermediary that maintains one or
          more enumerated U.S. relationships. Backup withholding is not an additional tax
          and may be claimed as a credit against the U.S. federal income tax liability of
          a non-U.S. holder, or alternatively, the non-U.S. holder may be eligible for a
          refund of any excess amounts withheld under the backup withholding rules, in
          either case, provided that the required information is furnished to the
Internal           Revenue Service.

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|F. | Dividend
and Paying Agents
|-- | --------------------------

Not applicable.

|G. | Statement
by Agents
|-- | -------------------

Not applicable.

|H. | Documents
on Display
|-- | --------------------

BluePhoenix
is subject to the reporting requirements of the Exchange Act of 1934, as amended, that are
applicable to a foreign private issuer. In accordance with the Exchange Act, we file with
the SEC reports, including annual reports on Form 20-F by June 30 each year. In addition,
we file interim financial information on Form 6-K on a quarterly basis. We also furnish to
the SEC under cover of Form 6-K certain other material information required to be made
public in Israel, filed with and made public by any stock exchange or distributed by us to
our shareholders. You may inspect without charge and copy at prescribed rates such
material at the public reference facilities maintained by the SEC, 100 F Street, N.E.,
Washington, D.C. 20549. You may also obtain copies of such material from the SEC at
prescribed rates by writing to the Public Reference Section of the SEC, 100 F Street,
N.E., Washington, D.C. 20549. Please call the SEC at 1-800-SEC-0330 for further
information on the public reference room.

The
SEC maintains an Internet site at http://www.sec.gov that contains reports and other
material that are filed through the SECs Electronic Data Gathering, Analysis and
Retrieval (EDGAR) system. BluePhoenix began filing through the EDGAR system
beginning on November 14, 2002.

BluePhoenixs
ordinary shares are quoted on the NASDAQ National Market. You may inspect reports and
other information concerning BluePhoenix at the offices of the National Association of
Securities Dealers, Inc., 1735 K Street, N.E., Washington, D.C. 20006. You may also find
our reports filed with the ISA on the Magna site whose address is
http://www.magna.isa.gov.il.

Our
Internet address is http://www.bphx.com. A copy of each report submitted in accordance
with applicable United States law is available for public review at our principal
executive offices.

94

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|I. | Subsidiary
Information
|-- | ----------------------

Not applicable.

|ITEM 11. | QUANTITATIVE
AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
|-------- | ----------------------------------------------------------

In
light of the nature of our activities, we invest our cash and cash equivalents, in
short-term time deposits. As of December 31, 2005, we invested substantially all of the
cash we held in dollars, euro and DKK currency accounts. In addition, we had outstanding
loans in dollars, euro and NIS. Fluctuations in foreign currency exchange rates, such as
euro or NIS versus the dollar may have a negative impact on our operating results and
financial condition. Accordingly, the interest rates that we pay may also have a major
impact on our financial expenses. Our interest expenses are most sensitive to the changes
in the London Interbank Offered Rate (LIBOR) since most of our borrowings are linked to
the LIBOR. As of December 31, 2005, we had approximately $11.9 million in outstanding
loans linked to the LIBOR. Depending upon the circumstances, we enter from time to time
into currency and interest options and forward transactions to decrease the risk of
financial exposure from fluctuations in the exchange rate of the dollar versus any other
applicable foreign currencies, and the changes in the LIBOR.

|ITEM 12. | DESCRIPTION
OF SECURITIES OTHER THAN EQUITY SECURITIES
|-------- | ------------------------------------------------------

Not applicable.

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# P A R T II

---

|ITEM 13. | DEFAULTS,
DIVIDEND ARREARAGES AND DELINQUENCIES
|-------- | -----------------------------------------------

Not applicable.

|ITEM 14. | MATERIAL
MODIFICATIONS TO THE RIGHTS OF SECURITY HOLDERS AND USE OF PROCEEDS
|-------- | ----------------------------------------------------------------------------

Not applicable.

|ITEM 15. | CONTROLS
AND PROCEDURES
|-------- | -----------------------

(a)
Disclosure Controls and Procedures.We have carried out an evaluation, as
          of the end of our fiscal year, under the supervision and with the participation
          of our management, including our chief executive officer and chief financial
          officer, of our internal control over financial reporting and the effectiveness
          of the design and operation of our disclosure controls and procedures. Based
          upon that evaluation, the chief executive officer and chief financial officer
          concluded that our disclosure controls and procedures are effective in assuring
          that all material information relating to our company is made known to them.

(b)
Internal Controls.Since the date of the evaluation described above,
          there have been no significant changes in our internal controls over financial
          reporting or in other factors that have materially affected, or are reasonably
          likely to materially affect, our internal control over financial reporting.

|ITEM 16A. | AUDIT
COMMITTEE FINANCIAL EXPERT
|--------- | --------------------------------

Our
board of directors has determined that Mr. Michael Chill and Ms. Amira Berkovitz-Amir,
both members of our audit committee, are audit committee financial experts, as defined by
applicable SEC regulations.

|ITEM 16B. | CODE
OF ETHICS
|--------- | --------------

BluePhoenix
has adopted a code of business conduct and ethics applicable to its executive officers,
directors and all other employees. A copy of the code is available to all
BluePhoenixs employees, investors and others upon request to the following address:
BluePhoenix Solutions Ltd. 8 Maskit St. Herzliya 46120, Israel, Attn: Legal Advisor. Any
waiver of this code for executive officers or directors will be disclosed through the
filing of a Form 6-K.

96

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|ITEM 16C. | PRINCIPAL
ACCOUNTANT FEES AND SERVICES
|--------- | --------------------------------------

Policy of Preapproval of
Audit and Non-Audit Services of Independent Auditors

Our
audit committee is responsible for the oversight of our independent auditors work.
The audit committees policy is to preapprove all audit and non-audit services
provided by Ziv Haft independent registered public accounting BDO member firm. These
services may include audit services, audit-related services, tax services and other
services, as further described below. The audit committee sets forth the basis for its
preapproval in detail, listing the particular services or categories of services that are
preapproved, and setting forth a specific budget for such services. Additional services
may be preapproved by the audit committee on an individual basis. Once services have been
preapproved, Ziv Haft independent registered public accountant BDO member firm and our
management then report to the audit committee on a periodic basis regarding the extent of
services actually provided in accordance with the applicable preapproval, and regarding
the fees for the services performed.

Principal Accountant Fees
and Services

BluePhoenix
paid the following fees for professional services rendered by Ziv Haft independent
registered certified public accountants (Isr.) and other BDO member firm, for the years
ended December 31, 2004 and 2005:

|                   | 2005 | 2004
|------------------ | ---- | ----
|
|
|
|
|Audit Fees         |      |     
|Audit-Related Fees |      |     
|Tax Fees           |      |     
|All Other Fees     |      |     
|                   |      |     
|Total              |      |     

The
audit fees for the years ended December 31, 2005 and 2004 were for professional services
rendered for the audits of our annual consolidated financial statements, review of our
consolidated quarterly financial statements, statutory audits of BluePhoenix and its
subsidiaries, issuance of comfort letters, consents and assistance with review of
documents filed with the SEC.

The
audit-related fees for the year ended December 31, 2004 were for assurance and related
services in connection with acquisitions,
issuance of convertible debentures and related warrants and review of our registration
statement by the SEC.

97

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Tax
fees for the years ended December 31, 2005 and 2004 were for services related to tax
compliance, including the preparation of tax returns and claims for refund, and tax
planning and tax advice, including assistance with tax audits and appeals, tax services
for employee benefit plans and assistance with respect to requests for rulings from tax
authorities.

|ITEM 16D. | EXEMPTIONS
FROM THE LISTING STANDARDS FOR AUDIT COMMITTEES
|--------- | ----------------------------------------------------------

Not applicable.

|ITEM 16E. | PURCHASES
OF EQUITY SECURITIES BY THE ISSUER AND AFFILIATED PURCHASERS
|--------- | ----------------------------------------------------------------------

None.

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# P A R T III

---

|ITEM 17. | FINANCIAL
STATEMENTS
|-------- | --------------------

We
have responded to Item 18 in lieu of this item.

|ITEM 18. | FINANCIAL
STATEMENTS
|-------- | --------------------

|The
financial statements required by this item are found at the end of this annual report,
beginning on page F-1.
|-----------------------------------------------------------------------------------------------------------------

|ITEM 19. | EXHIBITS
|-------- | --------

# Exhibit No.

|1.1 |  | English
translation of the Memorandum of Association as amended on July 23, 2003(1)
|--- |  | -----------------------------------------------------------------------------------

|1.2 |  | Articles
of Association as amended on December 27, 2005
|--- |  | -------------------------------------------------------

|4.1 |  | Cooperation
agreement dated August 10, 1999, between ForSoft Ltd. and the Registrant (English
                       summary accompanied by Hebrew original) (2)
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.2 |  | Agreement
dated June 12, 2003, among the Registrant, the owners of all of the issued and
outstanding common stock of IntraComp Group Incorporated (3)
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------

|4.3 |  | Agreement
dated January 11, 2001 among the Registrant, the Israel Mezzanine Fund L.P., The
                        Israel Mezzanine Fund, The Jordan (Bermuda) Investment Company
Ltd.(4)
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.4 |  | Amendment
dated August 7, 2003 to agreement among the Registrant, the Israel Mezzanine Fund
                        L.P., The Israel Mezzanine Fund and The Jordan (Bermuda)
Investment Company Ltd. dated January                         11, 2001 (5)
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.5 |  | Share
Purchase Agreement dated March 30, 2004, among the Registrant and four institutional
investors in connection with a $5 million private placement(6)
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------

|4.6 |  | Amendment
dated February 18, 2005 to Share Purchase Agreement among the Registrant and four
institutional investors in connection with a $5 million private placement(6)
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------

99

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# Exhibit No.

|4.7 |  | Registration
Rights Agreement dated March 30, 2004, among the Registrant and four institutional
investors in connection with a $5 million private placement(6)
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.8 |  | Share
Exchange Agreement dated October 13, 2002 among the Registrant, Formula Systems (1985)
and certain shareholders of Liraz Systems Ltd.(3)
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------

|4.9 |  | The
1996 Share Option Plan  Part One, as amended on January 28, 1997, December 5, 1999,
December 18, 2000, December 26, 2000 and August 6, 2003(5)
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------

|4.10 |  | Agreement
dated January 1, 1996 among the Registrant and Argotec Ltd.(7)
|---- |  | ------------------------------------------------------------------------

|4.11 |  | Form
of voting agreement dated September 30, 1996 between Argotec Ltd. and each of Dan
Goldstein                        and Gad Goldstein(7)
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------

|4.12 |  | English
translation of Loan Agreement between Liraz Systems Ltd. and Arie Kilman dated April 2000
                       as amended by the Addendum dated April 2002(5)
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.13 |  | Form
of Indemnification Letter dated December 27, 2005 between the Registrant and certain
office                        holders
|---- |  | -------------------------------------------------------------------------------------------------------------------------------

|4.14 |  | Summary
of credit line Letter Agreement between the Registrant and Bank Leumi Le'Israel Ltd.(5)
|---- |  | -----------------------------------------------------------------------------------------------

|4.15 |  | Master
Services Agreement between BluePhoenix Solutions Nordic AS and SDC Udvikling A/S dated
                       October 1, 2002
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------

|8 |  | List
of Subsidiaries
|- |  | --------------------

|12.1 |  | Certification
of the Chief Executive Officer pursuant toss.302 of the Sarbanes-Oxley Act
|---- |  | ----------------------------------------------------------------------------------------

|12.2 |  | Certification
of the Chief Financial Officer pursuant toss.302 of the Sarbanes-Oxley Act
|---- |  | ----------------------------------------------------------------------------------------

|13.1 |  | Certification
of the Chief Executive Officer pursuant to 18 U.S.C.ss.1350, as adopted pursuant to
                     ss.906 of the Sarbanes-Oxley Act
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------

|13.2 |  | Certification
of the Chief Financial Officer pursuant to 18 U.S.C.ss.1350, as adopted pursuant to
                     ss.906 of the Sarbanes-Oxley Act
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------

|15 |  | Consent
of Ziv Haft registered certified public accountants (Isr.) BDO member firm
|-- |  | ----------------------------------------------------------------------------------

100

---

---



---

| | (1) Incorporated
by reference to the Registration Statement on Form F-1 filed with                     the
Securities and Exchange Commission on December 24, 1996.
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (2) Incorporated
by reference to the Registrant annual report on Form 20-F filed                     with
the Securities and Exchange Commission on June 28, 2002.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (3) Incorporated
by reference to the Registrant annual report on Form 20-F filed                     with
the Securities and Exchange Commission on June 19, 2003.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (4) Incorporated
by reference to the Registrant annual report on Form 20-F filed                     with
the Securities and Exchange Commission on June 29, 2001.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (5) Incorporated
by reference to the Registrant annual report on Form 20-F filed                     with
the Securities and Exchange Commission on June 1, 2004, as amended on
                    November 9, 2004.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (6) Incorporated
by reference to the Registration Statement on Form F-3                filed with the
Securities and Exchange Commission on June 1, 2004, as amended on                November
9, 2004 and on February 18, 2005.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (7) Incorporated
by reference to Amendment No. 1 to the Registration                Statement on Form F-1
filed with the Securities and Exchange Commission on                January 28, 1997.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

SIGNATURES

The registrant hereby certifies that
it meets all of the requirements for filing on Form 20-F and that it has duly caused and
authorized the undersigned to sign this annual report on its behalf.

| |  | BLUEPHOENIX SOLUTIONS LTD.
(Registrant)BY: /S/ Iris Yahal
Iris YahalChief Financial Officer
| |  | ---------------------------------------------------------------------------------------------------------

Date: March 27, 2006

101

---

---



# EXHIBIT INDEX

# Exhibit No.

|1.1 |  | English
translation of the Memorandum of Association as amended on July 23, 2003(1)
|--- |  | -----------------------------------------------------------------------------------

|1.2 |  | Articles
of Association as amended on December 27, 2005
|--- |  | -------------------------------------------------------

|4.1 |  | Cooperation
agreement dated August 10, 1999, between ForSoft Ltd. and the Registrant (English
                       summary accompanied by Hebrew original) (2)
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.2 |  | Agreement
dated June 12, 2003, among the Registrant, the owners of all of the issued and
outstanding common stock of IntraComp Group Incorporated (3)
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------

|4.3 |  | Agreement
dated January 11, 2001 among the Registrant, the Israel Mezzanine Fund L.P., The
                        Israel Mezzanine Fund, The Jordan (Bermuda) Investment Company
Ltd.(4)
|--- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.4 |  | Amendment
dated August 7, 2003 to agreement among the Registrant, the Israel Mezzanine Fund
                        L.P., The Israel Mezzanine Fund and The Jordan (Bermuda)
Investment Company Ltd. dated January                         11, 2001 (5)
|--- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.5 |  | Share
Purchase Agreement dated March 30, 2004, among the Registrant and four institutional
investors in connection with a $5 million private placement(6)
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------

|4.6 |  | Amendment
dated February 18, 2005 to Share Purchase Agreement among the Registrant and four
institutional investors in connection with a $5 million private placement(6)
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.7 |  | Registration
Rights Agreement dated March 30, 2004, among the Registrant and four institutional
investors in connection with a $5 million private placement(6)
|--- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------

|4.8 |  | Share
Exchange Agreement dated October 13, 2002 among the Registrant, Formula Systems (1985)
and certain shareholders of Liraz Systems Ltd.(3)
|--- |  | ----------------------------------------------------------------------------------------------------------------------------------------------

|4.9 |  | The
1996 Share Option Plan  Part One, as amended on January 28, 1997, December 5, 1999,
December 18, 2000, December 26, 2000 and August 6, 2003(5)
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------

|4.10 |  | Agreement
dated January 1, 1996 among the Registrant and Argotec Ltd.(7)
|---- |  | ------------------------------------------------------------------------

|4.11 |  | Form
of voting agreement dated September 30, 1996 between Argotec Ltd. and each of Dan
Goldstein                        and Gad Goldstein(7)
|---- |  | --------------------------------------------------------------------------------------------------------------------------------------------

|4.12 |  | English
translation of Loan Agreement between Liraz Systems Ltd. and Arie Kilman dated April 2000
                       as amended by the Addendum dated April 2002(5)
|---- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------

2

---

---



# Exhibit No.

|4.13 |  | Form
of Indemnification Letter dated December 27, 2005 between the Registrant and certain
office                        holders
|---- |  | -------------------------------------------------------------------------------------------------------------------------------

|4.14 |  | Summary
of credit line Letter Agreement between the Registrant and Bank Leumi Le'Israel Ltd.(5)
|---- |  | -----------------------------------------------------------------------------------------------

|4.15 |  | Master
Services Agreement between BluePhoenix Solutions Nordic AS and SDC Udvikling A/S dated
                       October 1, 2002
|---- |  | ------------------------------------------------------------------------------------------------------------------------------------

|8 |  | List
of Subsidiaries
|- |  | --------------------

|12.1 |  | Certification
of the Chief Executive Officer pursuant toss.302 of the Sarbanes-Oxley Act
|---- |  | ----------------------------------------------------------------------------------------

|12.2 |  | Certification
of the Chief Financial Officer pursuant toss.302 of the Sarbanes-Oxley Act
|---- |  | ----------------------------------------------------------------------------------------

|13.1 |  | Certification
of the Chief Executive Officer pursuant to 18 U.S.C.ss.1350, as adopted pursuant to
                     ss.906 of the Sarbanes-Oxley Act
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------

|13.2 |  | Certification
of the Chief Financial Officer pursuant to 18 U.S.C.ss.1350, as adopted pursuant to
                     ss.906 of the Sarbanes-Oxley Act
|---- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------

|15 |  | Consent
of Ziv Haft registered certified public accountants (Isr.) BDO member firm
|-- |  | ----------------------------------------------------------------------------------

---

| | (1)                    the
Securities and Exchange Commission on December 24, 1996.
| | -----------------------------------------------------------------------------------

| | (2) Incorporated
by reference to the Registrant annual report on Form 20-F filed                     with
the Securities and Exchange Commission on June 28, 2002.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (3) Incorporated
by reference to the Registrant annual report on Form 20-F filed                     with
the Securities and Exchange Commission on June 19, 2003.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (4) Incorporated
by reference to the Registrant annual report on Form 20-F filed                     with
the Securities and Exchange Commission on June 29, 2001.
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (5) Incorporated
by reference to the Registrant annual report on Form 20-F filed                     with
the Securities and Exchange Commission on June 1, 2004, as amended on
                    November 9, 2004.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (6) Incorporated
by reference to the Registration Statement on Form F-3                filed with the
Securities and Exchange Commission on June 1, 2004, as amended on                November
9, 2004 and on February 18, 2005.
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (7) Incorporated
by reference to Amendment No. 1 to the Registration                Statement on Form F-1
filed with the Securities and Exchange Commission on                January 28, 1997.
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

3

---

---

BLUEPHOENIX SOLUTIONS LTD.
(An Israeli Corporation)
2005 Annual Report



---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

2005
CONSOLIDATED FINANCIAL STATEMENTS

TABLE
OF CONTENTS

|                                                        |  |           
|------------------------------------------------------- |  | ----------
|                                                        |  | Page      
|                                                        |  |           
|                                                        |  |           
|Report of Independent Registered Public Accounting Firm |  | F-1       
|                                                        |  |           
|Balance Sheets                                          |  | F-2       
|                                                        |  |           
|Statements of Operations                                |  | F-3       
|                                                        |  |           
|Statements of Changes in Shareholders Equity           |  | F-4       
|                                                        |  |           
|Statements of Cash Flows                                |  | F-5 - F-6 
|                                                        |  |           
|Notes to Financial Statements                           |  | F-7 - F-63

The
amounts are stated in U.S. dollars ($).

---

---



REPORT OF
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Shareholders and Board of Directors of

BLUEPHOENIX
SOLUTIONS LTD.

We have
audited the accompanying consolidated balance sheets of BluePhoenix Solutions
Ltd. (the Company) and its subsidiaries as of December 31, 2005 and 2004 and
the related consolidated statements of operations, changes in shareholders
equity and cash flows for each of the three years in the period ended December
31, 2005. These financial statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these financial
statements based on our audits.

We conducted
our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The company is not required to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting.

Our audits
included consideration of internal control over financial reporting as a basis
for designing audit procedures that are appropriate in the circumstances, but
not for the purpose of expressing an opinion on the effectiveness of the
Companys internal control over financial reporting. Accordingly, we express no
such opinion. An audit also includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, as
well as evaluating the overall financial statement presentation. We believe
that our audits provide a reasonable basis for our opinion.

In our
opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of the
Company and its subsidiaries as of December 31, 2005 and 2004, and the related
consolidated results of its operations and cash flows for each of the three
years in the period ended December 31, 2005,
in conformity with accounting principles generally accepted in the United
States.

As discussed
more fully in Note 11A1, there were public reports in early 2004 that Microsoft
source code was leaked to the Internet, with source traces coming from the
Companys subsidiary. While the Companys subsidiary believes its relationship
with Microsoft will continue on terms acceptable to the Companys subsidiary, a
change in the relationship could materially adversely affect the Companys
subsidiarys business, results of operations, and financial condition.

Tel Aviv,
Israel
March 27, 2006

| |                                    
| | -----------------------------------
| | Ziv Haft                           
| | Certified Public Accountants (Isr.)
| | BDO Member Firm                    

F-1

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

CONSOLIDATED BALANCE SHEETS

|                                                                                                                                                                                                           |  | December
  31,   |        
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | -------
|                                                                                                                                                                                                           |  |                  |        
|                                                                                                                                                                                                           |  | 2005             |        
|                                                                                                                                                                                                           |  |                  |        
|                                                                                                                                                                                                           |  | (in
  thousands) |        
|                                                                                                                                                                                                           |  |                  |        
|ASSETS                                                                                                                                                                                                     |  |                  |        
|CURRENT ASSETS (Note 13):                                                                                                                                                                                  |  |                  |        
|Cash and cash equivalents                                                                                                                                                                                  |  | $                | 10,791 
|Marketable securities                                                                                                                                                                                      |  |                  | -      
|Trade accounts receivable (Note 15A1)                                                                                                                                                                      |  |                  | 18,143 
|Other current assets (Note 15A2)                                                                                                                                                                           |  |                  | 2,495  
|                                                                                                                                                                                                           |  |                  |        
|Total current assets                                                                                                                                                                                       |  |                  | 31,429 
|                                                                                                                                                                                                           |  |                  |        
|                                                                                                                                                                                                           |  |                  |        
|INVESTMENTS
  IN AFFILIATES AND OTHER COMPANIES (Note 3)                                                                                                                                                   |  |                  | 370    
|                                                                                                                                                                                                           |  |                  |        
|PROPERTY AND EQUIPMENT, NET (Note 4, 15D2)                                                                                                                                                                 |  |                  |        
|Cost                                                                                                                                                                                                       |  |                  | 11,465 
|Less - accumulated depreciation                                                                                                                                                                            |  |                  | 9,305  
|                                                                                                                                                                                                           |  |                  |        
|                                                                                                                                                                                                           |  |                  | 2,160  
|                                                                                                                                                                                                           |  |                  |        
|GOODWILL
  (Note 5)                                                                                                                                                                                        |  |                  | 38,832 
|                                                                                                                                                                                                           |  |                  |        
|SOFTWARE DEVELOPMENT COSTS AND OTHER (Note 6)                                                                                                                                                              |  |                  | 26,900 
|                                                                                                                                                                                                           |  |                  |        
|                                                                                                                                                                                                           |  |                  |        
|Total assets                                                                                                                                                                                               |  | $                | 99,691 
|                                                                                                                                                                                                           |  |                  |        
|LIABILITIES
  AND SHAREHOLDERS EQUITY                                                                                                                                                                     |  |                  |        
|CURRENT LIABILITIES (Note 13):                                                                                                                                                                             |  |                  |        
|Short-term bank credit and others (Note
7)                                                                                                                                                                 |  | $                | 14,095 
|Accounts payable and accruals:                                                                                                                                                                             |  |                  |        
|Trade                                                                                                                                                                                                      |  |                  | 3,088  
|Deferred revenue                                                                                                                                                                                           |  |                  | 2,776  
|Other (Note 15A3)                                                                                                                                                                                          |  |                  | 6,924  
|                                                                                                                                                                                                           |  |                  |        
|Total current liabilities                                                                                                                                                                                  |  |                  | 26,883 
|                                                                                                                                                                                                           |  |                  |        
|LONG-TERM
  LIABILITIES:                                                                                                                                                                                   |  |                  |        
|Convertible debentures (Note 12B4)                                                                                                                                                                         |  |                  | 4,342  
|Accrued severance pay, net (Note 8)                                                                                                                                                                        |  |                  | 1,309  
|Provision for losses in formerly-consolidated
subsidiary (Note 9)                                                                                                                                          |  |                  | 1,971  
|Loans from banks and others (Note 10)                                                                                                                                                                      |  |                  | 8,389  
|                                                                                                                                                                                                           |  |                  |        
|Total long-term liabilities                                                                                                                                                                                |  |                  | 16,011 
|                                                                                                                                                                                                           |  |                  |        
|MINORITY
  INTEREST                                                                                                                                                                                        |  |                  | 5,031  
|                                                                                                                                                                                                           |  |                  |        
|COMMITMENTS
  AND CONTINGENCIES (Note 11)                                                                                                                                                                  |  |                  |        
|SHAREHOLDERS
  EQUITY (Note 12):                                                                                                                                                                          |  |                  |        
|Share capital - ordinary shares of NIS 0.01 par value
  (authorized: December 31, 2005 and 2004 - 30,000,000 shares; issued: December
  31, 2005 15,430,403 shares; December 31, 2004 - 15,420,104 shares) |  |                  | 31     
|Capital surplus                                                                                                                                                                                            |  |                  | 56,205 
|Accumulated other comprehensive loss                                                                                                                                                                       |  |                  | (1,537 
|Retained earnings                                                                                                                                                                                          |  |                  | 11,775 
|                                                                                                                                                                                                           |  |                  |        
|                                                                                                                                                                                                           |  |                  | 66,474 
|                                                                                                                                                                                                           |  |                  |        
|Cost of 1,870,565 Company shares held by
subsidiaries                                                                                                                                                      |  |                  | (14,708
|                                                                                                                                                                                                           |  |                  |        
|Total shareholders equity                                                                                                                                                                                 |  |                  | 51,766 
|                                                                                                                                                                                                           |  |                  |        
|Total liabilities and shareholders equity                                                                                                                                                                 |  | $                | 99,691 
|                                                                                                                                                                                                           |  |                  |        

The accompanying
notes are an integral part of the consolidated financial statements.

F-2

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

CONSOLIDATED STATEMENTS OF OPERATIONS

|                                                            |  |                                         |        |      |   |        |   |   |        |  
|----------------------------------------------------------- |  | --------------------------------------- | ------ | ---- | - | ------ | - | - | ------ | -
|                                                            |  | Year ended
  December 31,               |       
|                                                            |  |                                         |       
|                                                            |  | 2005                                    |        | 2004 |   | 2003   |  
|                                                            |  |                                         |        |      |   |        |  
|                                                            |  | (in
  thousands, except per share data) |       
|                                                            |  |                                         |       
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|Revenues
  (Note 15D1)                                      |  | $                                       | 58,947 |      | $ | 57,186 |   | $ | 54,340 |  
|Cost of
  revenues                                          |  |                                         | 25,379 |      |   | 24,253 |   |   | 24,115 |  
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|Gross profit                                                |  |                                         | 33,568 |      |   | 32,933 |   |   | 30,225 |  
|Software
  development costs, net                           |  |                                         | 8,006  |      |   | 8,055  |   |   | 8,138  |  
|Selling,
  general, and administrative expenses             |  |                                         | 21,611 |      |   | 21,388 |   |   | 20,140 |  
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|Operating income                                            |  |                                         | 3,951  |      |   | 3,490  |   |   | 1,947  |  
|Financial
  income (expenses), net (Note 15B2)              |  |                                         | (1,978 | )    |   | (882   | ) |   | 165    |  
|Gain on
  realization of shareholdings (Note 15B3)          |  |                                         | -      |      |   | 112    |   |   | 376    |  
|Other
  income, net (Note 15B4)                             |  |                                         | 104    |      |   | 975    |   |   | 567    |  
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|Income before taxes on income                               |  |                                         | 2,077  |      |   | 3,695  |   |   | 3,055  |  
|Taxes on
  income (Note 14)                                 |  |                                         | 149    |      |   | 260    |   |   | 152    |  
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|                                                            |  |                                         | 1,928  |      |   | 3,435  |   |   | 2,903  |  
|Share in
  losses of affiliated companies, net              |  |                                         | -      |      |   | (516   | ) |   | (898   | )
|Minority
  interest in profits of subsidiaries              |  |                                         | (139   | )    |   | (73    | ) |   | (154   | )
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|Net income                                                  |  | $                                       | 1,789  |      | $ | 2,846  |   | $ | 1,851  |  
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|Earnings per share (Note 15C):                              |  |                                         |        |      |   |        |   |   |        |  
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|Basic                                                       |  | $                                       | 0.13   |      | $ | 0.21   |   | $ | 0.14   |  
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|Diluted                                                     |  | $                                       | 0.13   |      | $ | 0.21   |   | $ | 0.14   |  
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|Weighted average number of shares
  outstanding (Note 15C): |  |                                         |        |      |   |        |   |   |        |  
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|Basic                                                       |  |                                         | 13,557 |      |   | 13,523 |   |   | 13,451 |  
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|                                                            |  |                                         |        |      |   |        |   |   |        |  
|Diluted                                                     |  |                                         | 13,960 |      |   | 14,679 |   |   | 13,644 |  
|                                                            |  |                                         |        |      |   |        |   |   |        |  

The accompanying
notes are an integral part of the consolidated financial statements.

F-3

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

CONSOLIDATED STATEMENTS OF CHANGES IN
SHAREHOLDERS EQUITY

|                                                               |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|-------------------------------------------------------------- |  | ------------------------------- | ---------- | --------- | - | ------------------------------ |  | ------------------------------------------------- | ------ | ------------------- | - | ------------------------------------------------- | - | ----- | ------ |  | - | ------- | - | - | ------ | -
|                                                               |  | Share
  capital                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |        
|                                                               |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |        
|                                                               |  | Number of
  shares              |            | Par value |   | Additional
  paid-in
  capital |  | Accumulated other
  comprehensive
  income (loss) |        | Retained
  earnings |   | Cost of
  Company
  shares held by
  subsidiaries |   | Total |       
|                                                               |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |       
|                                                               |  | (in
  thousands, except shares) |           
|                                                               |  |                                 |           
|Balance at
  December 31, 2002                                 |  |                                 | 13,449,009 |           | $ | 30                             |  | $                                                 | 54,329 |                     | $ | 1,781                                             |   | $     | 5,289  |  | $ | (14,708 | ) | $ | 46,721 |  
|Changes
  during 2003:                                         |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|Components of comprehensive income:                            |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|Net income                                                     |  |                                 | -          |           |   | -                              |  |                                                   | -      |                     |   | -                                                 |   |       | 1,851  |  |   | -       |   |   | 1,851  |  
|Currency translation adjustments                               |  |                                 | -          |           |   | -                              |  |                                                   | -      |                     |   | (3,257                                            | ) |       | -      |  |   | -       |   |   | (3,257 | )
|                                                               |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|Total comprehensive loss                                       |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   | (1,406 | )
|                                                               |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|Exercise of employee share options                             |  |                                 | 35,267     |           |   | -                              |  |                                                   | 83     |                     |   | -                                                 |   |       | -      |  |   | -       |   |   | 83     |  
|                                                               |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|Balance at
  December 31, 2003                                 |  |                                 | 13,484,276 |           |   | 30                             |  |                                                   | 54,412 |                     |   | (1,476                                            | ) |       | 7,140  |  |   | (14,708 | ) |   | 45,398 |  
|Changes
  during 2004:                                         |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|Components of comprehensive income:                            |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|Net income                                                     |  |                                 | -          |           |   | -                              |  |                                                   | -      |                     |   | -                                                 |   |       | 2,846  |  |   | -       |   |   | 2,846  |  
|Currency translation adjustments                               |  |                                 | -          |           |   | -                              |  |                                                   | -      |                     |   | (155                                              | ) |       | -      |  |   | -       |   |   | (155   | )
|                                                               |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|Total comprehensive income                                     |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   | 2,691  |  
|                                                               |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|Issuance of shares (Note 2E)                                   |  |                                 | 31,496     |           |   | 1                              |  |                                                   | 199    |                     |   | -                                                 |   |       | -      |  |   | -       |   |   | 200    |  
|Issuance of options                                            |  |                                 | -          |           |   | -                              |  |                                                   | 48     |                     |   | -                                                 |   |       | -      |  |   | -       |   |   | 48     |  
|Beneficial conversion features                                 |  |                                 | -          |           |   | -                              |  |                                                   | 173    |                     |   | -                                                 |   |       | -      |  |   | -       |   |   | 173    |  
|Exercise of employee share options                             |  |                                 | 33,767     |           |   | -                              |  |                                                   | 121    |                     |   | -                                                 |   |       | -      |  |   | -       |   |   | 121    |  
|                                                               |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|Balance at
  December 31, 2004                                 |  |                                 | 13,549,539 |           |   | 31                             |  |                                                   | 54,953 |                     |   | (1,631                                            | ) |       | 9,986  |  |   | (14,708 | ) |   | 48,631 |  
|Changes
  during 2005:                                         |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|Components of comprehensive income:                            |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|Net income                                                     |  |                                 | -          |           |   | -                              |  |                                                   | -      |                     |   | -                                                 |   |       | 1,789  |  |   | -       |   |   | 1,789  |  
|Currency translation adjustments                               |  |                                 | -          |           |   | -                              |  |                                                   | -      |                     |   | 94                                                |   |       | -      |  |   | -       |   |   | 94     |  
|                                                               |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|Total comprehensive income                                     |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   | 1,883  |  
|                                                               |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|Issuance of options                                            |  |                                 | -          |           |   | -                              |  |                                                   | 48     |                     |   | -                                                 |   |       | -      |  |   | -       |   |   | 48     |  
|Change in fair value of a conversion feature upon
modification |  |                                 | -          |           |   | -                              |  |                                                   | 325    |                     |   | -                                                 |   |       | -      |  |   | -       |   |   | 325    |  
|Classification of warrants to equity                           |  |                                 | -          |           |   | -                              |  |                                                   | 848    |                     |   | -                                                 |   |       | -      |  |   | -       |   |   | 848    |  
|Exercise of employee share options                             |  |                                 | 10,299     |           |   | -                              |  |                                                   | 31     |                     |   | -                                                 |   |       | -      |  |   | -       |   |   | 31     |  
|                                                               |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  
|Balance at
  December 31, 2005                                 |  |                                 | 13,559,838 |           | $ | 31                             |  | $                                                 | 56,205 |                     | $ | (1,537                                            | ) | $     | 11,775 |  | $ | (14,708 | ) | $ | 51,766 |  
|                                                               |  |                                 |            |           |   |                                |  |                                                   |        |                     |   |                                                   |   |       |        |  |   |         |   |   |        |  

The accompanying
notes are an integral part of the consolidated financial statements.

F-4

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

CONSOLIDATED STATEMENTS OF CASH FLOWS

|                                                                                    |  |                           |         |      |   |        |   |   |        |  
|----------------------------------------------------------------------------------- |  | ------------------------- | ------- | ---- | - | ------ | - | - | ------ | -
|                                                                                    |  | Year ended
  December 31, |        
|                                                                                    |  |                           |        
|                                                                                    |  | 2005                      |         | 2004 |   | 2003   |  
|                                                                                    |  |                           |         |      |   |        |  
|                                                                                    |  | (in
  thousands)          |        
|                                                                                    |  |                           |        
|CASH FLOWS FROM OPERATING ACTIVITIES:                                               |  |                           |         |      |   |        |   |   |        |  
|Net income                                                                          |  | $                         | 1,789   |      | $ | 2,846  |   | $ | 1,851  |  
|Adjustments to reconcile net income to net
  cash provided by operating activities: |  |                           |         |      |   |        |   |   |        |  
|Minority interests in profits of
  subsidiaries                                     |  |                           | 139     |      |   | 73     |   |   | 154    |  
|Share in losses of affiliated companies,
  net                                      |  |                           | -       |      |   | 516    |   |   | 898    |  
|Depreciation and amortization                                                       |  |                           | 7,001   |      |   | 4,430  |   |   | 3,910  |  
|Increase (decrease) in accrued severance
  pay, net                                 |  |                           | (343    | )    |   | (362   | ) |   | 96     |  
|Loss (gain) on sale of property and
  equipment                                     |  |                           | (35     | )    |   | 14     |   |   | 31     |  
|Gain on realization of shareholdings and
  expiration of options                    |  |                           | -       |      |   | (112   | ) |   | (451   | )
|Write-down of loans to an investee                                                  |  |                           | -       |      |   | -      |   |   | 350    |  
|Write-down of shareholdings in an
investee                                          |  |                           | -       |      |   | -      |   |   | 100    |  
|Change in value of long term-loans and
  liabilities                                |  |                           | 410     |      |   | 275    |   |   | (92    | )
|                                                                                   
|Decrease of provision for losses in
  formerly consolidated subsidiary              |  |                           | -       |      |   | -      |   |   | (541   | )
|Deferred income taxes, net                                                          |  |                           | 58      |      |   | (104   | ) |   | 513    |  
|Changes in operating assets and
liabilities:                                        |  |                           |         |      |   |        |   |   |        |  
|Decrease in marketable securities                                                   |  |                           | 177     |      |   | 600    |   |   | 234    |  
|Increase in trade receivables                                                       |  |                           | (1,221  | )    |   | (2,011 | ) |   | (2,022 | )
|Decrease (increase) in other current
assets                                         |  |                           | 544     |      |   | (335   | ) |   | 647    |  
|Increase (decrease) in trade payables                                               |  |                           | (1,939  | )    |   | 437    |   |   | (193   | )
|Decrease in other accounts payable                                                  |  |                           | (1,388  | )    |   | (5,138 | ) |   | (3,027 | )
|                                                                                    |  |                           |         |      |   |        |   |   |        |  
|Net cash provided by operating
activities                                           |  |                           | 5,192   |      |   | 1,129  |   |   | 2,458  |  
|                                                                                    |  |                           |         |      |   |        |   |   |        |  
|CASH FLOWS FROM INVESTING ACTIVITIES:                                               |  |                           |         |      |   |        |   |   |        |  
|Purchase of property and equipment                                                  |  |                           | (700    | )    |   | (1,118 | ) |   | (867   | )
|Proceeds from sale of property and
  equipment                                      |  |                           | 277     |      |   | 203    |   |   | 157    |  
|Investment in and loans to affiliated and
  other companies                         |  |                           | (370    | )    |   | (97    | ) |   | (1,140 | )
|Repayment of loan                                                                   |  |                           | -       |      |   | 68     |   |   | -      |  
|Proceeds from sale of investments                                                   |  |                           | -       |      |   | 2,777  |   |   | 376    |  
|Capitalization of software development and
  other costs                            |  |                           | (8,117  | )    |   | (7,117 | ) |   | (3,159 | )
|Purchase of minority interest in
  subsidiaries                                     |  |                           | (180    | )    |   | -      |   |   | (2,730 | )
|Investment in newly-consolidated
  subsidiaries (Appendix A)                        |  |                           | (1,343  | )    |   | (95    | ) |   | -      |  
|Realization of investment in
  previously-consolidated subsidiaries (Appendix B)    |  |                           | -       |      |   | -      |   |   | (152   | )
|                                                                                    |  |                           |         |      |   |        |   |   |        |  
|Net cash used in investing activities                                               |  |                           | (10,433 | )    |   | (5,379 | ) |   | (7,515 | )
|                                                                                    |  |                           |         |      |   |        |   |   |        |  
|CASH FLOWS FROM FINANCING ACTIVITIES:                                               |  |                           |         |      |   |        |   |   |        |  
|Short-term bank credit, net                                                         |  |                           | 153     |      |   | (2,350 | ) |   | 495    |  
|Repayment of long-term loans                                                        |  |                           | (542    | )    |   | (2,063 | ) |   | -      |  
|Receipt of long-term loans                                                          |  |                           | 7,003   |      |   | 2,443  |   |   | -      |  
|Issuance in a subsidiary to minority
  shareholders                                 |  |                           | -       |      |   | -      |   |   | 313    |  
|Issuance of convertible debentures and
  warrants                                   |  |                           | -       |      |   | 5,000  |   |   | -      |  
|Debentures issuance expense                                                         |  |                           | -       |      |   | (643   | ) |   | -      |  
|Exercise of employee share options                                                  |  |                           | 31      |      |   | 121    |   |   | 83     |  
|                                                                                    |  |                           |         |      |   |        |   |   |        |  
|Net cash provided by financing
activities                                           |  |                           | 6,645   |      |   | 2,508  |   |   | 891    |  
|                                                                                    |  |                           |         |      |   |        |   |   |        |  
|EFFECT OF FOREIGN EXCHANGE RATE CHANGES ON
  CASH                                   |  |                           | 24      |      |   | -      |   |   | (35    | )
|                                                                                    |  |                           |         |      |   |        |   |   |        |  
|                                                                                    |  |                           |         |      |   |        |   |   |        |  
|NET INCREASE
  (DECREASE) IN CASH AND CASH EQUIVALENTS                              |  |                           | 1,428   |      |   | (1,742 | ) |   | (4,201 | )
|CASH AND
  CASH EQUIVALENTS AT BEGINNING OF YEAR                                    |  |                           | 9,363   |      |   | 11,105 |   |   | 15,306 |  
|                                                                                    |  |                           |         |      |   |        |   |   |        |  
|CASH AND
  CASH EQUIVALENTS AT END OF YEAR                                          |  | $                         | 10,791  |      | $ | 9,363  |   | $ | 11,105 |  
|                                                                                    |  |                           |         |      |   |        |   |   |        |  

The
accompanying notes are an integral part of the consolidated financial
statements.

F-5

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

CONSOLIDATED
STATEMENTS OF CASH FLOWS

|                                                  |  |                           |       |      |   |       |  |   |     | 
|------------------------------------------------- |  | ------------------------- | ----- | ---- | - | ----- |  | - | --- | 
|                                                  |  | Year ended
  December 31, |      
|                                                  |  |                           |      
|                                                  |  | 2005                      |       | 2004 |   | 2003  | 
|                                                  |  |                           |       |      |   |       | 
|                                                  |  | (in
  thousands)          |      
|                                                  |  |                           |      
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: |  |                           |       |      |   |       |  |   |     | 
|Cash paid during the year for:                    |  |                           |       |      |   |       |  |   |     | 
|Income taxes                                      |  | $                         | 1,221 |      | $ | 1,316 |  | $ | 415 | 
|Interest                                          |  | $                         | 864   |      | $ | 443   |  | $ | 537 | 

APPENDIX A 
INVESTMENT IN NEWLY-CONSOLIDATED SUBSIDIARIES:

|                                                |  |                           |        |      |   |        |   |   |   | 
|----------------------------------------------- |  | ------------------------- | ------ | ---- | - | ------ | - | - | - | 
|                                                |  | Year ended
  December 31, |       
|                                                |  |                           |       
|                                                |  | 2005                      |        | 2004 |   | 2003   |  
|                                                |  |                           |        |      |   |        |  
|                                                |  | (in
  thousands)          |       
|                                                |  |                           |       
|Working
  capital, other than cash              |  | $                         | 105    |      | $ | 2,631  |   | $ | - | 
|Investment
  in and loans to affiliated Company |  |                           | -      |      |   | 27     |   |   | - | 
|Property and
  equipment                        |  |                           | (100   | )    |   | (373   | ) |   | - | 
|Minority
  interest                             |  |                           | -      |      |   | 98     |   |   | - | 
|Customer
  related intangible assets and other  |  |                           | (564   | )    |   | (425   | ) |   | - | 
|Goodwill                                        |  |                           | -      |      |   | (283   | ) |   | - | 
|Capitalized
  software development costs        |  |                           | (1,158 | )    |   | (6,056 | ) |   | - | 
|Non-current
  liabilities                       |  |                           | 374    |      |   | 4,086  |   |   | - | 
|Company
  shares issued upon acquisition        |  |                           | -      |      |   | 200    |   |   | - | 
|                                                |  |                           |        |      |   |        |   |   |   | 
|Net cash used in acquisition                    |  | $                         | (1,343 | )    | $ | (95    | ) | $ | - | 
|                                                |  |                           |        |      |   |        |   |   |   | 

APPENDIX B 
REALIZATION OF PREVIOUSLY-CONSOLIDATED SUBSIDIARIES:

|                                                |  |                           |   |      |   |      |  |   |        |  
|----------------------------------------------- |  | ------------------------- | - | ---- | - | ---- |  | - | ------ | -
|                                                |  | Year ended
  December 31, |  
|                                                |  |                           |  
|                                                |  | 2005                      |   | 2004 |   | 2003 | 
|                                                |  |                           |   |      |   |      | 
|                                                |  | (in
  thousands)          |  
|                                                |  |                           |  
|Working
  capital, other than cash              |  | $                         | - |      | $ | -    |  | $ | 226    |  
|Investment
  in and loans to affiliated Company |  |                           | - |      |   | -    |  |   | (2,613 | )
|Property and
  equipment                        |  |                           | - |      |   | -    |  |   | 145    |  
|Other assets                                    |  |                           | - |      |   | -    |  |   | 49     |  
|Minority
  interest                             |  |                           | - |      |   | -    |  |   | 21     |  
|Goodwill                                        |  |                           | - |      |   | -    |  |   | 2,132  |  
|Severance
  pay                                 |  |                           | - |      |   | -    |  |   | (112   | )
|                                                |  |                           |   |      |   |      |  |   |        |  
|Total                                           |  | $                         | - |      | $ | -    |  | $ | (152   | )
|                                                |  |                           |   |      |   |      |  |   |        |  

APPENDIX C  NON-CASH
ACTIVITIES:

|                                                                                                              |  |                           |       |      |   |      |  |   |       | 
|------------------------------------------------------------------------------------------------------------- |  | ------------------------- | ----- | ---- | - | ---- |  | - | ----- | 
|                                                                                                              |  | Year ended
  December 31, |      
|                                                                                                              |  |                           |      
|                                                                                                              |  | 2005                      |       | 2004 |   | 2003 | 
|                                                                                                              |  |                           |       |      |   |      | 
|                                                                                                              |  | (in
  thousands)          |      
|                                                                                                              |  |                           |      
|Purchase of technology from an affiliate
  offset against an outstanding loan that was given to the affiliate |  | $                         | -     |      | $ | -    |  | $ | 1,917 | 
|Investment in subsidiaries                                                                                    |  | $                         | 1,577 |      |   | -    |  |   | -     | 
|Purchase of minority interest in
  subsidiaries                                                               |  | $                         | 100   |      |   | -    |  |   | -     | 

The accompanying
notes are an integral part of the consolidated financial statements.

F-6

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                              
|-------- | ---------------------------------------------
|Note 1  | Summary
  of Significant Accounting Policies:

|   |                                                                                       |              |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-- | ------------------------------------------------------------------------------------- | ------------ | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | General:                                                                             
|   |                                                                                      
|   | The significant accounting
  policies, applied on a consistent basis, are as follows:
|   |                                                                                      
|   | 1.                                                                                    | The Company:
|   |                                                                                       |             
|   |                                                                                       | a)           | BluePhoenix Solutions Ltd.
  (BluePhoenix) (together with its subsidiaries, the Company) is an Israeli
  corporation, which operates in one reportable operating business segment
  enterprise IT modernization solutions. The Company develops and markets
  software tools and provides consulting services for efficient modernization
  of legacy systems and cross-platform migration. The Company manages its
  business in various international markets through several entities, including
  its wholly-owned subsidiaries located in: USA, UK, Denmark, Germany, Italy,
  Netherlands, Cyprus, Romania, and Israel. Listed below are details relating
  to BluePhoenixs major subsidiaries:

| |                                      |  |                           |     |                          |  |     |  |  |             | 
| | ------------------------------------ |  | ------------------------- | --- | ------------------------ |  | --- |  |  | ----------- | 
| |                                      |  | Shareholding
  percentage |     | State of
  incorporation | 
| |                                      |  |                           |     |                          | 
| | Name                                 |  | 2005                      |     | 2004                     |  |     |  | 
| |                                      |  |                           |     |                          |  |     |  | 
| |                                      |  | %                         |     |                          |  |    
| |                                      |  |                           |     |                          |  |    
| | Subsidiaries:                        |  |                           |     |                          |  |     |  |  |             | 
| | BluePhoenix Solutions B.V. *         |  |                           | 100 |                          |  | 100 |  |  | Netherlands | 
| | BluePhoenix Solutions Nordic Aps *   |  |                           | 100 |                          |  | 100 |  |  | Denmark     | 
| | Advanced Systems Europe B.V. *       |  |                           | 100 |                          |  | 100 |  |  | Netherlands | 
| | Liraz Systems Ltd. (Liraz)         |  |                           | 100 |                          |  | 100 |  |  | Israel      | 
| | Mainsoft Corporation (Mainsoft)    |  |                           | 58  |                          |  | 58  |  |  | USA         | 
| | Outlook & BluePhoenix Ltd.           |  |                           | 100 |                          |  | 100 |  |  | Israel      | 
| | Liacom Ltd.                          |  |                           | 51  |                          |  | 51  |  |  | Israel      | 
| | I-Ter/Informatica & Territorio S.P.A |  |                           | 100 |                          |  | -   |  |  | Italy       | 

---

| |    |                                                                                                                                                   |                                                                                                                            
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------
| |    | b)                                                                                                                                                | In July 2003, the name of
  the Company was changed from Crystal Systems Solutions Ltd. to BluePhoenix
  Solutions Ltd.
| |    |                                                                                                                                                   |                                                                                                                            
| | 2. | Principal Shareholder:                                                                                                                           
| |    |                                                                                                                                                  
| |    | Formula Systems (1985)
  Ltd. (Formula) owns 59.2% of the Companys shares as of December 31, 2005.                                            
| |    |                                                                                                                                                  
| | 3. | Accounting Principles:                                                                                                                           
| |    |                                                                                                                                                  
| |    | The consolidated financial
  statements are prepared in accordance with accounting principles generally
  accepted (GAAP) in the United States.

F-7

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                                      
|-------- | -----------------------------------------------------
|Note 1  | Summary
  of Significant Accounting Policies (cont.):

|   |                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|-- | ------------------ | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | General
  (cont.):
|   |                   
|   | 4.                 | Functional
  Currency:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   |                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                    | The currency of the
  primary economic environment in which the operations of the Company and most
  of its subsidiaries are conducted is the U.S. dollar (dollar). Most of the
  Companys sales are made outside of Israel (see Note 15D1 for export sales by
  geographic areas) and are denominated in dollars. In addition, a substantial
  portion of the Companys costs are incurred in dollars. Thus, the functional
  and reporting currency of the Company is considered to be the dollar. During
  the first quarter of 2003, some of the subsidiaries changed their functional
  currency from euro to U.S. dollar, which caused a reduction in the goodwill
  amount of approximately $3 million.
|   |                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                    | For consolidated companies
  whose functional currency is the dollar, transactions and balances originally
  denominated in dollars are presented at their original amounts. Balances in
  non-dollar currencies are translated into dollars using historical and
  current exchange rates for non-monetary and monetary balances, respectively.
  For non-dollar transactions reflected in the statements of operations, the
  exchange rates at transaction dates are used. Amortization and depreciation
  deriving from non-monetary items are based on historical exchange rates. The
  resulting transactions gains or losses are included in the statements of
  operations.                              
|   |                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                    | For consolidated companies
  whose functional currency is other than the dollar, transactions and balances
  have been translated to dollars under the principles prescribed in Statement
  of Financial Accounting Standards (SFAS) No. 52 of the Financial Accounting
  Standards Board (FASB). Assets and liabilities have been translated at
  period-end exchange rates. Results of operations have been translated at
  appropriately weighted average exchange rates. Differences resulting from
  such translation are presented as a separate component of shareholders
  equity under the caption Accumulated other comprehensive income.                                                       
|   |                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   | 5.                 | Use of Estimates and
  Assumptions in the Preparation of the Financial Statements:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   |                    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                    | The preparation of
  financial statements in conformity with generally accepted accounting
  principles requires management to make estimates and assumptions that affect
  the reported amounts of assets and liabilities, disclosure of contingent
  assets and liabilities at the dates of the financial statements and the
  reported amounts of revenues and expenses during the reporting periods.
  Actual results could differ from those estimates.                                                                                                                                                                                                                                                     

F-8

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                                      
|-------- | -----------------------------------------------------
|Note 1  | Summary
  of Significant Accounting Policies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Principles
  of Consolidation:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   | The consolidated financial
  statements include the accounts of BluePhoenix and its subsidiaries in which
  it has a controlling interest, and a certain variable interest entity that the
  Company is required to consolidate pursuant to Financial Accounting Standards
  Board Interpretation No. 46 Consolidation of Variable Interest Entities as
  revised in December 2003 (FIN 46)  See also Note 2H. Acquisition of
  subsidiaries is accounted for under the purchase method. All intercompany
  balances and transactions have been eliminated upon consolidation.                                                                                                               
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|C. | Cash and
  Cash Equivalents:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   | Cash equivalents are
  considered by the Company to be highly-liquid investments, including, inter
  alia, short-term deposits with banks, the maturity of which did not exceed
  three months at the time of deposit and which are not restricted.                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|D. | Provision
  for Doubtful Accounts:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   | The provision for doubtful
  accounts was based on of specific receivables the collection of which, in the
  opinion of Companys management, is in doubt. Trade receivables are charged
  off in the period in which they are deemed to be uncollectible.                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|E. | Investments:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   | Investments in affiliates
  over which the Company exercises significant influence are accounted for
  under the equity method. Investments in other companies are accounted for
  under the cost method. Investments in marketable securities are classified as
  trading, and unrealized gains or losses there from are reported in the
  statement of operations in accordance with the principles set forth in SFAS
  No. 115 Accounting for Certain Investments in Debt and Equity Securities.
  Investments are periodically reviewed to determine whether an
  other-than-temporary impairment in value has occurred, in which case the
  investment is written down to its fair value.

F-9

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                                      
|-------- | -----------------------------------------------------
|Note 1  | Summary
  of Significant Accounting Policies (cont.):

|   |                                                                                                                                                                                                                         
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|F. | Property
  and Equipment, Net:                                                                                                                                                                                          
|   |                                                                                                                                                                                                                         
|   | Property and equipment are
  stated at cost, net of accumulated depreciation. Depreciation is calculated
  by the straight-line method over their estimated useful lives. Annual rates
  of depreciation are as follows:

| |                                      |  |                                                                             
| | ------------------------------------ |  | ----------------------------------------------------------------------------
| |                                      |  | %                                                                           
| |                                      |  |                                                                             
|
| | Computers and peripheral
  equipment |  | 2033
  (mainly 33)                                                         
| | Office furniture and
  equipment     |  | 615
  (mainly 7)                                                           
| | Leasehold improvements               |  | Over
  the term of the lease or the life of the assets, whichever is shorter
| | Motor vehicles                       |  | 15                                                                          

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|G. | Impairment
  of Long-Lived Assets:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | The Companys long-lived
  assets are reviewed for impairment in accordance with SFAS No. 144
  Accounting for the Impairment or Disposal of Long-Lived Assets whenever
  events or changes in circumstances indicate that the carrying amount of an
  asset may not be recoverable. Recoverability of assets to be held and used is
  measured by a comparison of the carrying amount of an asset to the future
  undiscounted cash flows expected to be generated by the assets. If such
  assets are considered to be impaired, the impairment to be recognized is
  measured by the amount by which the carrying amount of the assets exceeds
  their fair value. During 2004 and 2005, no impairment losses have been
  identified.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|H. | Goodwill:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | In
  July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible
  Assets (SFAS No. 142). SFAS No. 142 requires goodwill to be tested for
  impairment on an annual basis and between annual tests in certain
  circumstances, and written down when impaired, rather than being amortized as
  previous accounting standards required. Furthermore, SFAS No. 142 requires
  purchased intangible assets other than goodwill to be amortized over their
  useful lives unless these lives are determined to be indefinite.                                                                                                                                                                                                 

F-10

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                                      
|-------- | -----------------------------------------------------
|Note 1  | Summary
  of Significant Accounting Policies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|-- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|H. | Goodwill
  (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   | SFAS No. 142 is effective
  for fiscal years beginning after December 15, 2001. The Company adopted SFAS
  No. 142 effective January 1, 2002. In accordance with SFAS No. 142, the
  Company ceased amortizing goodwill totaling $15.1 million as of the beginning
  of 2002. Based on the impairment tests performed during 2003, 2004, and 2005,
  no impairments losses have been identified. There can be no assurance that
  future goodwill impairment tests will not result in a charge to earnings.                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|I. | Software
  Development Costs:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   | Development costs of
  software and products enhancement that are intended for sale, and which were
  incurred after the establishment of technological feasibility of the relevant
  product, are capitalized. Technological
  feasibility is determined when detailed program design is completed and
  verified in accordance with the provisions of SFAS No. 86 Accounting for the
  Cost of Computers Software to Be Sold, Leased or Otherwise Marketed.
  Software development costs incurred before technological feasibility is
  established are charged to the statement of operations as incurred, net of
  participation of the Office of the Chief Scientist of the Israeli Ministry of
  Industry and Trade (the OCS).                                                                   
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   | Amortization of
  capitalized software development costs begins when the product is available
  for general release to customers. Annual amortization is computed by the
  straight-line method, over the remaining useful life of the product, or based
  on the ratio of current gross revenues to current and anticipated future
  gross revenues, whichever is higher. Currently, amortization is computed by
  the straight-line method over a period of five years. During the year ended
  December 31, 2005, the Company capitalized software development costs
  aggregating $8.0 million (in 2004: $7.1 million, and in 2003: $3.2 million)
  and amortized software development costs aggregating $5.1 million (in 2004:
  $3.1 million, and in 2003: $2.7million) included in cost of revenues.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   | In the Company
  managements estimate, total capitalized costs do not exceed the net
  realizable value of the software product. In the event that unamortized
  software development costs exceed the net realizable value of the product,
  they are written down to net realizable value.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              

F-11

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                                      
|-------- | -----------------------------------------------------
|Note 1  | Summary
  of Significant Accounting Policies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|J. | Employee
  Share Options:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | At December 31, 2005, the
  Company has one stock-based employee compensation plan, which is described
  more fully in Note 12B. The Company accounts for this plan under the
  recognition and measurement principles of APB Opinion No. 25, Accounting for
  Stock Issued to Employees, and related Interpretations. No stock-based
  employee compensation cost is charged to income, as all options granted under
  this plan had an exercise price equal to the market value of the underlying
  shares on the date of grant. The following table illustrates the effect on
  net income and earnings per share if the Company had applied the fair value
  recognition provisions of SFAS No. 123 of the FASB, Accounting for Stock-Based
  Compensation, to stock-based employee compensation.

| |                                                                                                                                               |  |                                         |         |      |   |       |   |   |       |  
| | --------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------------------------- | ------- | ---- | - | ----- | - | - | ----- | -
| |                                                                                                                                               |  | Year ended
  December 31,               |        
| |                                                                                                                                               |  |                                         |        
| |                                                                                                                                               |  | 2005                                    |         | 2004 |   | 2003  |  
| |                                                                                                                                               |  |                                         |         |      |   |       |  
| |                                                                                                                                               |  | (in
  thousands, except per share data) |        
| |                                                                                                                                               |  |                                         |        
|
| | Net income as reported                                                                                                                        |  | $                                       | 1,789   |      | $ | 2,846 |   | $ | 1,851 |  
|
| | Deduct: Total stock-based employee compensation expense determined
  under fair value based method for all awards, net of related tax effects |  |                                         | *(1,851 | )    |   | (624  | ) |   | (473  | )
| |                                                                                                                                               |  |                                         |         |      |   |       |   |   |       |  
| | Pro forma net income                                                                                                                          |  | $                                       | (62     | )    | $ | 2,222 |   | $ | 1,378 |  
| |                                                                                                                                               |  |                                         |         |      |   |       |   |   |       |  
| |                                                                                                                                               |  |                                         |         |      |   |       |   |   |       |  
| | Earnings per share:                                                                                                                           |  |                                         |         |      |   |       |   |   |       |  
|
| | Basic - as reported                                                                                                                           |  | $                                       | 0.13    |      | $ | 0.21  |   | $ | 0.14  |  
| |                                                                                                                                               |  |                                         |         |      |   |       |   |   |       |  
| | Basic - pro forma                                                                                                                             |  | $                                       | (0.00   | )    | $ | 0.16  |   | $ | 0.10  |  
| |                                                                                                                                               |  |                                         |         |      |   |       |   |   |       |  
| | Diluted - as reported                                                                                                                         |  | $                                       | 0.13    |      | $ | 0.21  |   | $ | 0.14  |  
| |                                                                                                                                               |  |                                         |         |      |   |       |   |   |       |  
| | Diluted - pro forma                                                                                                                           |  | $                                       | (0.00   | )    | $ | 0.16  |   | $ | 0.10  |  
| |                                                                                                                                               |  |                                         |         |      |   |       |   |   |       |  

|   |                                                                                                                                                                                                                                                                                                                                                                              |                                                                                
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------
|   | *                                                                                                                                                                                                                                                                                                                                                                            | Mainly due to an
  acceleration of unvested stock options  see also Note 12B1.
|   |                                                                                                                                                                                                                                                                                                                                                                              |                                                                                
|K. | Revenue
  Recognition:                                                                                                                                                                                                                                                                                                                                                      
|   |                                                                                                                                                                                                                                                                                                                                                                             
|   | Revenues derived from
  direct software license agreements are recognized in accordance with
  Statement of Position (SOP) 97-2 Software Revenue Recognition (as amended
  by SOP 98-4 and SOP 98-9), upon delivery of the software, when collection is
  probable, the license fee is otherwise fixed or determinable and persuasive
  evidence of an arrangement exists.
|   |                                                                                                                                                                                                                                                                                                                                                                             
|   | The arrangements that include multiple elements are
  usually arrangements where the Company sells software products and Post
  Contract Support (PCS).                                                                                                                                                                                                                     

F-12

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                                      
|-------- | -----------------------------------------------------
|Note 1  | Summary of Significant Accounting
  Policies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|K. | Revenue Recognition:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | In addition, there are certain arrangements where
  the Company sells software and consulting services.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | Consulting service fees are based on time invested.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | For these multiple elements, SOP 97-2 requires that
  the fair value of each component in a multiple element arrangement will be
  determined based on the vendors specific objective evidence (VSOE) for that
  element, and revenue is allocated to each component based on its fair value.
  SOP 98-9 requires that
  revenue be recognized under the residual method when VSOE does not exist
  for all the delivered elements, VSOE of fair value exists for all undelivered
  elements, and all other SOP 97-2 criteria are met. Under the residual method,
  any discount in the arrangement is allocated to the delivered elements. The
  specific objective evidence for the PCS is established by the price charged
  on separate PCS renewal contracts. The VSOE for the consulting services is
  established by the price charged on other time based consulting service
  contracts where no sale of other elements is involved, considering the
  territory where the service is performed, the size of the customer, the
  quantity of the purchased services, the professional expertise of the
  consultants, etc. The revenue associated with the delivered elements is
  recognized using the residual method discussed above.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | The Company recognizes revenues from consulting fees
  with respect to projects billed on a time and material basis, based on the
  number of hours performed.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | In some of the agreements with the Companys
  customers, the customers have the right to receive unspecified upgrades on an
  if-and-when available basis (the Company does not provide specific upgrades).
  These upgrades are considered Post-Contract Support (PCS). Revenue allocated
  to the PCS is recognized ratably over the term of the PCS.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | When a project involves significant production,
  modification, or customization of software, and for other fixed fee
  contracts, revenue is generally recognized according to the percentage of
  completion method, in accordance with the provisions of SOP 81-1 Accounting
  for Performance of Construction-Type Contracts. Under this method, estimated
  revenue is generally accrued based on costs incurred to date, as a percentage
  of total updated estimated costs.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

F-13

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                                      
|-------- | -----------------------------------------------------
|Note 1  | Summary
  of Significant Accounting Policies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|K. | Revenue
  Recognition (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | The Company recognizes
  contract losses, if any, in the period in which they first become evident.                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | Some of the Companys
  contracts include client acceptance clauses. In these contracts, the Company
  follows the guidance of TPA 5100.67 and SAB 104. In determining whether
  revenue can be recognized, when an acceptance clause exists, the Company
  considers its history with similar arrangements, the customers involvement
  in the progress, and the existence of other service providers and the
  payments terms. There are no rights of return, price protection or similar
  contingencies in the Companys contracts.        
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | Deferred revenue includes
  unearned amounts received under maintenance contracts and amounts received
  from customers but not yet recognized as revenues. Payments for maintenance
  fees are generally made in advance and are nonrefundable.                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | On December 31, 2005 approximately
  $7.8 million (on December 31, 2004: $5.1 million) of the accounts receivable
  balance was unbilled due to the customers payment terms. The Company believes
  the amount will be collected in one year in accordance with the contract
  terms.                                                                                                                                                                                                                                                           
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | Management believes that
  the Companys revenue recognition policies are in accordance with the
  Securities and Exchange Commission Staff Accounting Bulletin No. 101 and
  SAB 104, Revenue Recognition in Financial Statements.                                                                                                                                                                                                                                                                                                           
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|L. | Advertising
  Costs:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | The Company expenses
  advertising costs as incurred. Advertising costs for the years ended December
  31, 2005, 2004, and 2003 were $39, $25, and $26 thousand, respectively.                                                                                                                                                                                                                                                                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|M. | Gain on
  Realization of Shareholdings:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | Gain on realization of
  shareholdings includes the results of realization of the Companys
  shareholdings in investees arising either from the sale of such shareholdings
  or from issuance of stock by the investees to third parties, which is
  recognized in accordance with the provisions of Staff Accounting Bulletin
  (SAB) No. 51 of the Securities and Exchange Commission. The Company charges
  such results to statement of operations, provided that the conditions
  stipulated in SAB 51 for such recognition have been met.

F-14

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                                      
|-------- | -----------------------------------------------------
|Note 1  | Summary
  of Significant Accounting Policies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                       
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|N. | Deferred
  Income Taxes:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | The Company accounts for
  income taxes in accordance with Statement of Financial Accounting Standards
  No. 109, Accounting for Income Taxes (SFAS No. 109). This Statement
  prescribes the use of the liability method, whereby deferred tax asset and
  liability account balances are determined based on differences between
  financial reporting and the tax bases of assets and liabilities and are
  measured using the enacted tax rates and laws that will be in effect when the
  differences are expected to reverse. The Company provides a valuation
  allowance, when its more likely than not that deferred tax assets will not
  be realized in the foreseeable future.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|O. | Earnings
  Per Share:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | Earnings per share (EPS)
  were computed in accordance with the provisions of SFAS No. 128 of the FASB
  (SFAS No. 128). SFAS No. 128 requires the presentation of both basic and
  diluted EPS.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | Basic net earnings per
  share are computed based on the weighted average number of ordinary shares
  outstanding during each year. Diluted earnings per share is computed based on
  the weighted average number of ordinary shares outstanding during each year,
  plus dilutive potential ordinary shares considered outstanding during the
  year.                                                                                                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|P. | Financial
  Instruments:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | 1.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | Management
  of credit risks:                                                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | Financial instruments that
  have the potential to expose the Company to credit risks are mainly cash and
  cash equivalents, marketable securities, bank deposit accounts, and trade
  receivables.                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | The Company holds cash and
  cash equivalents, marketable securities, and deposit accounts at large banks
  in Israel, the United States, and the Netherlands, thereby substantially
  reducing the risk of loss.                                                                                                     
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | With respect to trade
  receivables, the risk is limited due to the nature and size of the entities
  that constitute the Companys customer base. The Company assesses the
  financial position of its customers prior to the engagement with them, and
  has not encountered material credit difficulties therewith.

F-15

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                                      
|-------- | -----------------------------------------------------
|Note 1  | Summary
  of Significant Accounting Policies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                         
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|P. | Financial
  Instruments (cont):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | 2.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              | Fair
  value of financial instruments:                                                                                                                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | The financial instruments
  of the Company consist mainly of cash and cash equivalents, short term
  investments, current receivables, long term loans and other investments,
  credit from banks, accounts payable and long term liabilities to banks. 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | The convertible debentures
  are valued using the discounted cash flows model based on the LIBOR interest
  rate. Warrants are priced using a Black-Scholes option pricing model.                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 | In view of their nature,
  the fair value of the financial instruments included in the Companys working
  capital is usually identical or close to their carrying value. The carrying
  value of equity-method investees approximates their fair value.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |                                                                                                                                                                                                                                                         
|Q. | Comprehensive
  Income:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | The Company adopted
  Statement of Financial Accounting Standards No.130, Reporting Comprehensive
  Income (SFAS 130). SFAS 130 establishes standards for reporting and
  presentation of comprehensive income and its components in a full set of
  general purpose financial statements.                                                                                                                                                                                                                                                                                                                                                                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | Comprehensive income
  presented in shareholders equity includes, in addition to net income (loss),
  translation gains and losses of non-dollar currency financial statements of
  subsidiaries (see also Note 1A4, with respect to the change in the functional
  currency).                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | The comprehensive income
  (loss) for the years ended December 31, 2003, 2004 and 2005 were $(1,406),
  $2,691 and $1,883 thousand, respectively.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|R. | Derivative
  Instruments:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | The
  Company has adopted Statement of Financial Accounting Standards SFAS No. 133
  Accounting for Derivative Instruments and Hedging Activities. Under the
  provisions of SFAS 133, all derivatives are recognized on the balance sheet
  at their fair value. Changes in fair value are recognized periodically in
  earnings or accumulated other comprehensive income within shareholders
  equity, depending on the intended use of the derivative and whether the
  derivative has been designated by management as a hedging instrument. Changes
  in fair value of derivative instruments not designated as hedging instruments
  are recognized in earnings in the current period.               
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | The
  Company uses foreign currency options and forward exchange contracts to assist
  in managing foreign currency exchange rate risk. The Company does not use
  derivative financial instruments for speculative purposes. These instruments
  are recognized at fair value, with all changes in fair value recorded in
  current period earnings, as these transactions have not been designated by
  management as hedging instruments under SFAS 133. The net gain recognized in
  earnings during 2005, representing the derivative instruments was $200
  thousand. As of December 31, 2005 the Company is obligated to purchase euro 3
  million at an average exchange rate of 1.195 euro per dollar.

F-16

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                                      
|-------- | -----------------------------------------------------
|Note 1  | Summary
  of Significant Accounting Policies (cont.):

|                                                                                                                                                                                                                       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|S.                                                                                                                                                                                                                     | Royalty-Bearing
  Grants:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|                                                                                                                                                                                                                       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                       | Royalty-bearing
  grants from the Government of Israel and other governmental institutions for
  funding approved research and development projects, are recognized at the
  time the Company is entitled to such grants. Such grants are included as a
  deduction of software development costs. The Company is committed to pay
  royalties on sales with regard of the funded products of approximately 3% of
  the generated revenues from such products. These royalties are recognized as
  incurred as costs of revenues.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|                                                                                                                                                                                                                       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|T.                                                                                                                                                                                                                     | Recently
  Issued Accounting Pronouncements:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|                                                                                                                                                                                                                       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|                                                                                                                                                                                                                       | In December 2004, the FASB
  issued FAS No. 123R, Share Based Payment. SFAS No. 123R requires that
  compensation costs related to share based payment transactions to be
  recognized in the financial statements. In most cases the amount of
  compensation cost will be measured based on the grant date fair value of the
  equity or liability issued. SFAS No. 123R requires all share-based payments
  to employees, including grants of employee stock options, to be recognized in
  the financial statements based on their fair values. Awards classified, as
  liabilities will be remeasured to fair value each reporting period. The
  compensation cost will be recognized over the period that the employee
  provides service in exchange for the award. Under SFAS No. 123R, the pro
  forma disclosures previously permitted no longer will be an alternative to
  financial statements recognition. SFAS No. 123R replaces SFAS No. 123,
  Accounting for Stock-Based Compensation and supersedes APB 25, Accounting
  for Stock Issued to Employees. SFAS No. 123R is effective for public entities
  as of the beginning of the first interim or annual reporting period that
  begins after June 15, 2005.
|                                                                                                                                                                                                                       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|In April 2005, the
  Securities and Exchange Commission announced the adoption of a new rule that
  amends the effective date for Statement No. 123R. The new rule does not
  change any of the accounting provisions.

F-17

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                                      
|-------- | -----------------------------------------------------
|Note 1  | Summary
  of Significant Accounting Policies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|-- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|T. | Recently
  Issued Accounting Pronouncements (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   | In March 2005, the SEC
  issued Staff Accounting Bulletin No.107 (SAB 107) regarding the SECs
  interpretation of SFAS 123R and the valuation of share-based payments for
  public companies. After assessing the potential impact of the provisions of
  SFAS No. 123R on the consolidated financial statements in
  fiscal year 2006, the Company decided to minimize
  its exposure to the accounting pronouncement by accelerating the vesting period of several outstanding unvested options. Effective
  December 27, 2005, the Company accelerated several outstanding
  unvested options under its 1996 Share Option Plan so as to be fully-vested as
  of such date (see Note 12B1). The Company will apply
  the modified prospective method, which requires that compensation expenses be
  recorded for all unvested share options upon adoption of SFAS No. 123R. The
  Company does not expect that the adoption of SFAS No. 123R will have a
  material impact on its consolidated results of operations and financial
  condition beginning in 2006.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   | In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error
  Corrections (SFAS 154), which replaces APB Opinion No. 20 Accounting
  Changes and SFAS No. 3, Reporting Accounting Changes in Interim Financial
  Statements  An Amendment of APB Opinion No. 28. SFAS 154 provides guidance
  on the accounting for and reporting of accounting changes and error
  corrections. It establishes retrospective application, or the latest
  practicable date, as the required method for reporting a change in accounting
  principle and the reporting of a correction of an error. SFAS 154 is
  effective for accounting changes and corrections of errors made in fiscal
  years beginning after December 15, 2005 and is required to be adopted by the
  Company in the first quarter of fiscal 2006. The Company is currently
  evaluating the effect that the adoption of SFAS 154 will have on its
  consolidated results of operations and financial condition but does not
  expect it to have a material impact.                        

F-18

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                                      
|-------- | -----------------------------------------------------
|Note 1  | Summary
  of Significant Accounting Policies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |                                                                                                                                        
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------
|T. | Recently
  Issued Accounting Pronouncements (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   | In November 2005, the FASB
  issued FSP FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary
  Impairment and Its Application to Certain Investments (FSP 115-1), which
  provides guidance on determining when investments in certain debt and equity
  securities are considered impaired, whether that impairment is
  other-than-temporary, and on measuring such impairment loss. FSP 115-1 also
  includes accounting considerations subsequent to the recognition of an
  other-than-temporary impairment and requires certain disclosures about
  unrealized losses that have not been recognized as other-than-temporary
  impairments. FSP 115-1 is required to be applied to reporting periods after
  December 15, 2005 and is required to be adopted by the Company in the first
  quarter of fiscal 2006. The Company is currently evaluating the effect that
  the adoption of FSP 115-1 will have on its consolidated results of operations
  and financial condition but does not expect it to have a material impact.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   | The adoption of the
  following recent accounting pronouncements did not have a material impact on
  the Companys results of operations and financial condition.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | SFAS No. 153, Exchanges
  of Nonmonetary Assets  An Amendment of APB Opinion No. 29, and                                            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |                                                                                                                                        
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    | FASB Interpretation No.
  47, Accounting for Conditional Asset Retirement Obligations, an
  interpretation of FASB Statement No. 143.

F-19

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                        
|-------- | -----------------------
|Note 2  | Certain
  Transactions:

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | Mainsoft:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | Mainsoft is a developer of
  software products that extend the productivity of the Visual Studio
  development environment to the J2EE, Unix, and Linux platforms. Since 1999,
  the Company has acquired 57.5% of the outstanding share capital of Mainsoft
  in a series of transactions, for an aggregate consideration of approximately
  $17.2 million. This holding includes the exercise of a warrant in May 2003,
  pursuant to which the Company purchased 630,000 shares of Mainsoft for an
  aggregate of $378 thousand (see also Note 11A1).                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|B. | IntraComp:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | IntraComp Group Inc.
  (IntraComp) provides migration and conversion services for large scale
  systems and back-end integration services. In 2000, the Company acquired a
  53% controlling interest in IntraComp for an aggregate consideration of
  approximately $3.4 million. IntraComps results of operations were
  consolidated in the Companys financial statements beginning with the second
  quarter of 2000.                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | During the second quarter
  of 2003, the Company purchased from other shareholders of IntraComp the
  remaining outstanding share capital of IntraComp for consideration to be
  calculated based on IntraComps cumulative earnings before interest and taxes
  during the three year period commencing on January 1, 2003. As a result, the
  Company currently wholly owns IntraComp. Goodwill arising upon acquisition
  was $191 thousand. Based on the final report of IntraComps earnings in the
  three-year period, the Company did not pay any consideration for the purchase
  of the remaining share capital.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|C. | Liraz:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | In November 2002, the
  Company purchased, through a share exchange transaction, approximately 86% of
  the outstanding share capital of Liraz Systems Ltd., (Liraz) an
  international software and services Company, developing and marketing
  AppBuilder, then publicly traded on the Tel Aviv Stock Exchange (TASE).                                                                                                                                                                                                                                                                                             

F-20

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                
|-------- | -------------------------------
|Note 2  | Certain
  Transactions (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                                                                                
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------
|C. | Liraz
  (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   | As part of the share
  exchange transaction, the Company issued to Lirazs selling shareholders,
  including Formula, 3,478,624 ordinary shares, constituting an aggregate of
  26% of the Companys outstanding share capital.                                                                                                                                                                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   | The acquisition of Liraz
  was recorded in the Companys accounts as follows:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   | -                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | With respect to Liraz
  shares acquired from Formula  at the carrying value in Formulas accounts,
  in the aggregate of $10.0 million.       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                                                                                
|   | -                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | With respect to Liraz
  shares acquired from other parties  at the market value of the consideration
  paid, in the aggregate of $2.9 million.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                                                                                
|   | The market value of the
  total consideration paid in this acquisition was $8.8 million. The purchase
  agreement with Liraz shareholders provided for a fixed exchange ratio between
  Liraz shares and the Company shares. The exchange ratio was based on the
  average ratio of the Companys share price to Lirazs share price in the
  three months prior to the signing of the agreement between the parties, in
  October 2002.                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   | In two public tender
  offers published by the Company in December 2002 and March 2003, the Company
  purchased additional shares of Liraz representing 9% of the outstanding share
  capital of Liraz.                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   | In March 2003, pursuant to
  the provisions of the Israeli Companies Law, the Company purchased the
  remaining outstanding share capital of Liraz. The total aggregate amount for
  those purchases was $2.7 million. Following these transactions, the Company
  currently holds the entire outstanding share capital of Liraz. The total
  carrying amount of the investment in Liraz following these transactions was
  $15.6 million. During 2003 and 2004, the Company assimilated and integrated
  Lirazs infrastructure, management, personnel, and sales and marketing
  activities within the Companys business.            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|D. | BluePhoenix
  Solutions Srl (previously known as AlphaTech (2000) Srl):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   | In December 2002, the
  Company purchased a 65% controlling interest in AlphaTech (2000) Srl. (AlphaTech)
  from Intercomp for an aggregate consideration of $100 thousand. In February
  2005, the Company entered into an agreement with the other shareholder of
  AlphaTech to purchase for $250 thousand its entire holdings in AlphaTech,
  which as of such date was equal to 35% of AlphaTechs outstanding share
  capital. In 2005, AlphaTech changed its name to BluePhoenix Solutions Srl.
  BluePhoenix Solutions Srl., a company incorporated in Romania, serves as the
  Companys offshore delivery center in Romania.

F-21

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                
|-------- | -------------------------------
|Note 2  | Certain
  Transactions (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|E. | CePost:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | In January 2004, the Company purchased the entire outstanding share capital of CePost Ltd., an Israeli Company
that develops and markets software solutions for electronic document mining, management, and presentation.
Pursuant to the purchase agreement, the Company paid $172.5 thousand to the shareholders of CePost and issued to
them 31,496 of BluePhoenix ordinary shares, valued at the fair value of $200 thousand. In addition, the Company
undertook to pay to the sellers a contingent consideration based on royalties generated from CePosts revenues in
an amount of up to $1.5 million. At its option, the Company may pay the contingent consideration in the form of
BluePhoenix ordinary shares.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | At acquisition, the
  Company accounted for the contingent purchase consideration at the minimum
  level of $120 thousand, in accordance with SFAS No. 141 and will be accounted
  as an additional cost of the acquired entity. In accordance with the purchase
  agreement, the Company paid the sellers in 2005 and 2006 advances in an
  aggregate amount of $45 thousand on account of the contingent consideration.
  In accordance with CePost results, there was no need to update the contingent
  purchase consideration.                                                                                                                                                                                      
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | The fair value assigned to
  CePosts technologies was $553 thousand and it is being amortized over a
  5-year period.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|F. | Outlook:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | Effective as of January
  2004, the Company acquired from an Israeli Company, Outlook Systems Ltd.
  through a new wholly-owned subsidiary, Outlook & BluePhoenix Ltd.,
  Outlook Systems entire business activities in Israel in the field of
  software development services. Pursuant to the purchase agreement, the
  Company hired 31 employees previously employed by Outlook Systems and assumed
  all the obligations in respect of the purchased activity. These obligations
  include the extension of a guarantee to a bank with respect to loans in an
  aggregate amount of $720 thousand plus interest accrued, to be repaid by the
  Company by February 15, 2007.                                       

F-22

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                
|-------- | -------------------------------
|Note 2  | Certain
  Transactions (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                    
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|F. | Outlook
  (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   | At acquisition, the
  Company accounted for the contingent purchase consideration at the minimum
  level of $720 thousand, in accordance with SFAS No. 141.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   | The value assigned to the
  customer related intangible asset amounted to $425 thousand, and it is being
  amortized over its estimated useful life-currently 6 years.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   | During 2005, the Company
  recorded an amount of $1,255 thousand as an additional payment in respect to
  the contingent purchase consideration, according to Outlook &
  BluePhoenixs results, which was allocated to goodwill based upon a purchase
  price allocation performed by the Company at acquisition date.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   | In
  the first quarter of 2006, the Company amended the terms of the purchase
  agreement with Outlook Systems. Pursuant to the amendment, in lieu of (i) the
  consideration payable to Outlook Systems under the purchase agreement; and
  (ii) the Companys obligation to extend a guarantee on behalf of Outlook
  Systems, the Company paid Outlook Systems an aggregate amount of $1.3 million.
  Accordingly, the guarantee extended to a bank with respect to Outlook Systems
  loans was cancelled. In addition, Outlook Systems received 138,591
  BluePhoenixs ordinary shares. As part of the amendment, the Company
  undertook to pay Outlook Systems a consideration to be calculated based on
  Outlook & BluePhoenix Ltd.s annual earnings before interest and taxes,
  referred to as EBIT, during the three-year period commencing on July 1, 2005,
  as follows:
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | For an amount of up to
  $300,000 of the annual EBIT in a each year within the three-year EBIT period,
  the Company will pay Outlook Systems a consideration equal to 10% of the
  EBIT;                          
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        | For an amount of annual
  EBIT in a fiscal year within the three-year EBIT period in excess of
  $300,000, the Company will pay Outlook Systems an additional consideration
  equal to 15% of the excessive amount.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |                                                                                                                                                                                                                    
|G. | Intercomp:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   | In 1998, the Company
  invested in Intercomp Ltd., (Intercomp), which has developed a set of
  automated analysis and reengineering tools for legacy COBOL applications.
  During 2002 and 2003, Intercomp focused its efforts on the development of
  software tools that comprise a part of the Companys LogicMiner tool.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         

F-23

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                
|-------- | -------------------------------
|Note 2  | Certain
  Transactions (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|G. | Intercomp
  (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | In the fourth quarter of
  2003, the Company exercised an option to purchase from Intercomp its tool,
  known as AnalyzeIT, for an aggregate of $1.9 million. In addition, the
  Company undertook to pay to Intercomp royalties of 25% of the revenues
  generated from the purchased technology. AnalyzeIT provides an analysis of a
  legacy application and creates a repository and inventory of the
  applications components and the relationship between them, presented
  graphically and in reports. The technology is being amortized over a 5-year
  period. In connection with the purchase of Intercomps technology, the
  Company assumed the rights and obligations of Intercomp under the
  distribution agreement described below.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | In March 2004, the Company
  exercised an option granted effective as of January 2004, to purchase from a
  former shareholder of Intercomp all of his holdings in Intercomp, consisting
  of 18.5% of the outstanding share capital of Intercomp. In consideration, the
  Company issued to the selling shareholder warrants to purchase 5,000 of
  BluePhoenix ordinary shares, at an exercise price of $20 per share, which
  expired on October 25, 2005 and were not exercised. As part of the transaction
  with the former shareholder, certain shareholders of Intercomp, holding 2.1%
  of Intercomps outstanding share capital, transferred their holdings in
  Intercomp to the Company. In addition, the remaining shareholders of
  Intercomp comprised of several funds acting through their general partner,
  Israel Infinity Venture Capital Partners Ltd., referred to as Infinity,
  converted certain outstanding loans owed to it by Intercomp into 7,236 shares
  of Intercomp at a price of $162.70 per share. Following these transactions,
  the Companys holdings in Intercomp increased from 49% to approximately 62%.
  Since the end of the first quarter of 2004, the Company consolidates the
  results of operations of Intercomp.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | Concurrently with the
  grant by the former shareholder of the option to purchase from him his
  holdings in Intercomp, Intercomp granted nonexclusive rights to a distributor
  partially owned by the former shareholder, to further develop and distribute
  Intercomps products.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               

F-24

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                
|-------- | -------------------------------
|Note 2  | Certain
  Transactions (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|G. | Intercomp
  (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | In April 2004, Infinity
  granted the Company a call option to purchase its entire holding in
  Intercomp, exercisable until April 1, 2006. If the Company does not exercise
  such option, Infinity will have a put option to cause the Company to purchase
  Infinitys entire holdings in Intercomp, exercisable during a period of
  six-month commencing in April 2006 (see Note 12B3).                                                                                                                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | In the first quarter of
  2006, First Israel Mezzanine Investors Ltd., known as FIMI, a creditor of
  Intercomp, has completed exercising a put option to sell the Company
  convertible promissory notes issued by Intercomp, in an aggregate principal
  amount of $3.5 million (see Note 12B2).                                                                                                                                                                                                                                                                                                                                                                                              
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|H. | M.S.I. MultiConn Solutions and MultiConn Technologies:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | In 1999, the Company
  acquired 51% of the outstanding share capital of M.S.I. MultiConn Solutions
  International (1995) Ltd. (M.S.I. MultiConn). M.S.I. MultiConns results of
  operations were consolidated in the Companys financial statements beginning
  with the third quarter of 1999. In 2000, the Company increased its holding in
  M.S.I. MultiConn to 60%.                                                                                                                                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | Since the first quarter of
  2003, the Company recorded its investment in M.S.I. MultiConn under the
  equity method and did not consolidate its results of operations, due to lack
  of control. Effective as of January 2004, the other shareholders of M.S.I.
  MultiConn transferred their entire holdings in M.S.I MultiConn to the
  Company. Following this transaction, the Company assumed control over the
  daily management of M.S.I. MultiConn. The Company currently wholly owns the
  entire share capital of M.S.I MultiConn and finances its activities.
  Effective as of the first quarter of 2004, M.S.I. MultiConns results are
  consolidated with the Companys results.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | In 2000, the Company
  established together with the other shareholders of M.S.I. MultiConn a
  company named MultiConn Technologies Ltd. and initially owned 19% of its
  share capital.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | MultiConn Technologies
  develops and markets WS4Legacy.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | In
  2002, the Company increased its holdings in MultiConn Technologies to 60% in
  2002. In 2003, the
  Company wrote down $350 thousand out of $1.1 million related to loans granted
  to MultiConn Technologies since it was probable that the Company will be not
  be able to collect all amounts due.                                                                                                                                                                                                                                                                                                                                                                                     
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | Since the first quarter of
  2003, the Company has recorded the investment under the equity method and did
  not consolidate the results of operation of MultiConn Technologies, due to
  lack of control.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      

F-25

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                
|-------- | -------------------------------
|Note 2  | Certain
  Transactions (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|-- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|H. | M.S.I.
  MultiConn Solutions and MultiConn Technologies (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   | Following a transaction
  entered into between the Company and the other shareholders of MultiConn
  Technologies in 2004, the other shareholders of MultiConn Technologies
  increased their holdings in MultiConn Technologies to 58.2% in the aggregate,
  through the issuance of shares by
  MultiConn Technologies. As a result, the Company currently holds
  approximately 40% of the outstanding share capital of MultiConn Technologies.
  The Company has an option to increase its holdings in MultiConn Technologies
  to 60% for an exercise price of $50 thousand.                                                                                                                                                                                                                                            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   | The Company provided a
  guarantee on behalf of MultiConn Technologies in the amount of $627 thousand
  as of December 31, 2005. In 2004, the Company included in share in losses of
  affiliated companies 100% of the losses of MultiConn Technologies up to the
  guaranteed amount granted in 2004.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   | In 2004, the Company did
  not recognize any gain in the above-mentioned transaction.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   | The Company is deemed the
  primary beneficiary of MultiConn Technologies in accordance with FIN 46R
  Consolidated of Variable Interest Entities, and accordingly consolidated
  MultiConn Technologies in its financial statements commencing December 31,
  2004 and thereafter. The adoption of FIN 46R has no impact on the Companys
  net income since it has already showed 100% of MultiConn Technologies losses
  in 2004 under the equity method.                                                                                                                                                                                                                                                                                                                                                               
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|I. | I-Ter/Informatica
  & Territorio S.p.A.:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   | In the second quarter of
  2005, the Company entered into an agreement to purchase the entire
  outstanding share capital of I-Ter/Informatica & Territorio S.p.A
  (I-Ter). Pursuant to the purchase agreement, the Company paid to the
  selling shareholders of I-Ter in the second quarter of 2005, $1.4 million.
  Under the terms of the transaction, the Company agreed to pay the selling
  shareholders an additional consideration of up to $720 thousand based on
  I-Ters cumulative earnings before interest and taxes, referred to as EBIT.
  As agreed, if the EBIT in any calendar year during the three-year period commencing
  on January 1, 2005, is equal to or greater than $6 thousand, the Company will pay the selling shareholders an additional
  $240 thousand with respect to each such year.

F-26

---

---



BLUEPHOENIX
SOLUTIONS LTD.
(An Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                
|-------- | -------------------------------
|Note 2  | Certain
  Transactions (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|I. | I-Ter/Informatica
  & Territorio S.p.A. (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | In addition, the
  Company agreed to pay to the selling shareholders, at such date that is 15
  business days following the date on which the EBIT report for the year ended
  on December 31, 2007 is final, an additional consideration equal to seven
  times of the yearly average EBIT in the three-year period commencing on
  January 1, 2005, less the amounts already paid to the selling shareholders
  for the purchased shares. In addition, in the event that the yearly average
  EBIT in the three-year period commencing on January 1, 2005 is greater than
  $600 thousand, the Company shall pay the selling shareholders an amount equal
  to nine times of the difference between the yearly average EBIT in the
  three-year period commencing on January 1, 2005 and $600 thousand.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | I-Ter is a developer
  and marketer of software solutions for migration from IMS DB (OS/390) or DL/I
  (VSE) to DB2, and from IMS DC to CICS, porting of applications from
  mainframe and Unix Sun Solaris.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | The consideration for the
  acquisition was attributed to net assets on the basis of fair value of assets
  acquired and liabilities assumed. Based upon a purchase price allocation
  performed by the Company, an amount of $498 thousand was allocated to the
  estimated fair value of the customer related intangible assets, which is
  being amortized over its estimated useful life  currently 3 years.                                                                                                                                                                                                                                                                                                                                                                                        
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | An amount of $1,158
  thousand of the purchase price was allocated to I-Ters core technology and
  is being amortized over 5-year period.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | The Company accounted for the contingent purchase consideration at the minimum level of $240 thousand as
goodwill, based upon a purchase price allocation performed by the Company at the acquisition date, in accordance
with SFAS No. 141. The Company will account for any change in that estimate as an additional cost of the acquired
entity.                                                                                                                                                                                                                                                                                                                                                                                                                                                      

F-27

---

---



BLUEPHOENIX SOLUTIONS LTD.
(An Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                              
|-------- | -----------------------------
|Note 2  | Certain Transactions (cont.):

|   |                                                                                                                                                                        
|-- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------
|I. | I-Ter/Informatica & Territorio S.p.A. (cont.):                                                                                                                         
|   |                                                                                                                                                                        
|   | The
  following table summarizes the fair values of the assets acquired and
  liabilities assumed with reference to I-Ters balance sheet as of the date of
  purchase.

| |                                                 |  |                  |       | 
| | ----------------------------------------------- |  | ---------------- | ----- | 
| |                                                 |  | (in
  thousands) |      
| |                                                 |  |                  |      
| |                                                 |  |                  |       | 
| | Current assets                                  |  | $                | 1,336 | 
| |                                                 |  |                  |       | 
| | Other long term intangible assets               |  |                  | 70    | 
| |                                                 |  |                  |       | 
| | Property and equipment, net                     |  |                  | 100   | 
| |                                                 |  |                  |       | 
| | Customer related intangible asset (1)           |  |                  | 498   | 
| |                                                 |  |                  |       | 
| | Technology (2)                                  |  |                  | 1,158 | 
| |                                                 |  |                  |       | 
| | Total tangible and intangible assets
  acquired |  |                  | 3,162 | 
| |                                                 |  |                  |       | 
| | Current liabilities                             |  |                  | 1,360 | 
| |                                                 |  |                  |       | 
| | Other long term liabilities                     |  |                  | 374   | 
| |                                                 |  |                  |       | 
| | Total liabilities assumed                       |  |                  | 1,734 | 
| |                                                 |  |                  |       | 
| | Net assets acquired                             |  | $                | 1,428 | 
| |                                                 |  |                  |       | 

| |     |                                                                                                
| | --- | -----------------------------------------------------------------------------------------------
| | (1) | The value assigned to
  customer related intangibles is being amortized currently over 3 years.
| |     |                                                                                                
| | (2) | The value assigned to
  technology is being amortized currently over 5 years.                  

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|J. | Unaudited Pro Forma Information:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   | The
  following unaudited pro forma summary presents information as if the
  acquisition of I-Ter had occurred as of January 1, 2005 and 2004, and as if
  certain acquisitions in 2004 had occurred as of January 1, 2004 and 2003. The
  pro forma information, which is provided for informational purposes only, is
  based on historical information and does not necessarily reflect the results
  that would have occurred, not is it necessarily indicative of future results
  of operations of the consolidated entity.

| |                                      |  |                                       |        |      |   |        |  |   |        |  
| | ------------------------------------ |  | ------------------------------------- | ------ | ---- | - | ------ |  | - | ------ | -
| |                                      |  | Year ended                            |       
| |                                      |  |                                       |       
| |                                      |  | December 31,                          |       
| |                                      |  |                                       |       
| |                                      |  | 2005                                  |        | 2004 |   | 2003   | 
| |                                      |  |                                       |       
| |                                      |  | (In thousands, except per share data) |       
| |                                      |  |                                       |       
| |                                      |  | ( U n a u d i t e d )                 |       
| |                                      |  |                                       |       
| |                                      |  |                                       |       
| | Revenues                             |  | $                                     | 59,444 |      | $ | 61,706 |  | $ | 57,671 |  
| |                                      |  |                                       |        |      |   |        |  |   |        |  
| | Net income
  (loss)                  |  | $                                     | 994    |      | $ | 2,624  |  | $ | (200   | )
| |                                      |  |                                       |        |      |   |        |  |   |        |  
| | Earning
  (loss) per share - basic   |  |                                       | 0.07   |      |   | 0.20   |  |   | (0.01  | )
| |                                      |  |                                       |        |      |   |        |  |   |        |  
| | Earning
  (loss) per share - diluted |  |                                       | 0.07   |      |   | 0.18   |  |   | (0.01  | )

F-28

---

---



BLUEPHOENIX SOLUTIONS LTD.
(An Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                              
|-------- | -----------------------------
|Note 2  | Certain Transactions (cont.):

|   |                                                                                                                                                         
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------
|K. | Following
  are the amounts assigned to major balance sheet components arising from the
  2004 acquisitions in the aggregate as of the date of purchase:

| |                                                 |  |                  |       | 
| | ----------------------------------------------- |  | ---------------- | ----- | 
| |                                                 |  | (in
  thousands) |      
| |                                                 |  |                  |      
| |                                                 |  |                  |       | 
| | Current assets                                  |  | $                | 1,517 | 
| |                                                 |  |                  |       | 
| | Other long term tangible assets                 |  |                  | 27    | 
| |                                                 |  |                  |       | 
| |                                                 |  |                  |       | 
| | Fixed assets                                    |  |                  | 373   | 
| |                                                 |  |                  |       | 
| | Total tangible assets acquired                  |  |                  | 1,917 | 
| |                                                 |  |                  |       | 
| | Goodwill                                        |  |                  | 283   | 
|
| | Customer related intangible asset (1)           |  |                  | 425   | 
| |                                                 |  |                  |       | 
| | Technology (2)                                  |  |                  | 5,998 | 
| |                                                 |  |                  |       | 
| | Total tangible and intangible assets
  acquired |  |                  | 8,623 | 
| |                                                 |  |                  |       | 
| | Current liabilities                             |  |                  | 3,776 | 
| |                                                 |  |                  |       | 
| | Other long term liabilities                     |  |                  | 3,965 | 
| |                                                 |  |                  |       | 
| | Total liabilities assumed                       |  |                  | 7,741 | 
| |                                                 |  |                  |       | 
| | Minority interest                               |  |                  | 98    | 
| |                                                 |  |                  |       | 
| | Net assets acquired                             |  | $                | 784   | 
| |                                                 |  |                  |       | 

| |     |                                                                                                 
| | --- | ------------------------------------------------------------------------------------------------
| | (3) | The value
  assigned to customer related intangibles is being amortized currently over 6
  years
|
| | (4) | The value
  assigned to technology is being amortized currently over 5 years                    

|         |                                               
|-------- | ----------------------------------------------
|Note 3  | Investments in Affiliates and Other Companies:

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | Zulu
  Software Inc.:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   | In February
  2005, the Company entered into an agreement to purchase up to 20% of the
  outstanding share capital of Zulu Software, Inc. (Zulu), on a fully diluted
  basis. Under the purchase agreement, the purchase price was divided into four
  installments, each to be paid subject to fulfillment of certain milestones.
  The company paid the first installment of $350 thousand in February 2005
  against the issuance of 8% of Zulus outstanding share capital. The Company
  did not make additional payments because the agreed upon milestones have not
  been reached.

F-29

---

---



BLUEPHOENIX SOLUTIONS LTD. 
(An Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                                       
|-------- | ------------------------------------------------------
|Note 3  | Investments in Affiliates and Other Companies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | Zulu
  Software Inc. (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | In January
  2006, the Company purchased from the other shareholders of Zulu additional
  shares increasing its holdings to 72% of Zulus outstanding share capital.
  The aggregate consideration paid for this additional purchase was $2.4
  million. In addition, in February 2005, the Company entered into an alliance
  agreement with Zulu for cooperation in marketing and selling Zulus and the
  Companys software tools and services.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | Zulu is a
  developer and marketer of software solutions for migration from
  ADABAS/Natural to RDBMS/Java.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|B. | Tesnet:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | Effective as
  of January 1999, the Company acquired 32% of the outstanding share capital of
  Tesnet  Software Testing Ltd. (Tesnet). During 1999 and 2002, the Company
  paid approximately $2 million for its holding in Tesnet, as Tesnet met an
  agreed upon earnings target within three years following the acquisition.
  Total goodwill arising from this acquisition was $886 thousand. In February
  2000, Tesnet consummated a public offering of its shares and warrants on the
  Tel Aviv Stock Exchange. As a result, the Companys holdings in Tesnet
  decreased to 22%. Until December 2003, the Companys investment in Tesnet was
  accounted for under the equity method, owing to the fact that the Company
  exercises significant influence over operating and financial policies of
  Tesnet by virtue of its representation on Tesnets board of directors. During
  2003, $112 thousand were recorded as income from an increase in the Companys
  equity investment in Tesnet due to the expiration of the above-mentioned
  warrants. In the first quarter of 2004, the Company sold its entire remaining
  holdings in Tesnet for an aggregate consideration of approximately $3.1
  million. As a result, the Company currently does not hold any interest in
  Tesnet (see Note 15B3)
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|C. | Level 8:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | The Company
  holds several capital instruments, including warrants and rights to receive
  warrants exercisable into shares of Level 8 Systems Inc. (Level 8). If the
  Company exercises these capital instruments in full, it will hold
  approximately 13 million ordinary shares of Level 8.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | In 2003, the
  Company purchased 444,444 ordinary shares of Level 8 for $200 thousand.
  During 2003 and the first quarter of 2004, the Company sold substantially all
  of the shares of Level 8 then held by the Company, for $624 thousand.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

F-30

---

---



BLUEPHOENIX SOLUTIONS LTD.
(An Israeli Corporation)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                                       
|-------- | ------------------------------------------------------
|Note 3  | Investments in Affiliates and Other Companies (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|C. | Level 8
(cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   | The Company
  provides to Bank HaPoalim a guarantee to secure Level 8s loan from the
  bank. As of December 31, 2005, this guarantee amounted to approximately $2
  million (see Note 9). The guarantee is extended from time to time and it is
  currently in effect until November 2006.In consideration for the extension
  of the guarantee, Level 8 issued the Company 300,000 ordinary shares and is
  entitled to be granted an additional 6,342,000 ordinary shares of Level 8. In
  addition, the Company has been granted warrants to purchase 3,600,000
  ordinary shares of Level 8 at an exercise price of $0.02. The amount of the
  guarantee outstanding was unchanged since the amount remained the same and
  the shares were issued only in connection with the extension of the term of
  the guarantee. In the event that the guarantee is exercised, the bank is
  obligated to grant the Company a three-year loan in an amount of up to the
  amount of the guarantee. In September 2004, the Company extended a loan
  granted to Level 8 of approximately $97 thousand under a secured promissory
  note. The note bears interest at an annual rate of 10%. In consideration, the
  Company is entitled to receive warrants to purchase 1,986,468 ordinary shares
  of Level 8 at an exercise price of $0.10 per share.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|D. | Steps Ventures:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   | As of
  December 31, 2005, the Company holds 375,000 shares of Steps Ventures Ltd. comprising
  3.75% of the outstanding share capital of Steps Ventures. Steps Ventures is
  an Israeli venture capital investment group focused on Israeli startup
  companies in the fields of software, telecommunications and semiconductors.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 

F-31

---

---



BLUEPHOENIX SOLUTIONS LTD. 
(An Israeli Corporation) 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                             
|-------- | ----------------------------
|Note 4  | Property and Equipment, Net:

Composition of
property and equipment, grouped by major classifications:

| |                                    |  |                |        |      |   |        | 
| | ---------------------------------- |  | -------------- | ------ | ---- | - | ------ | 
| |                                    |  | December 31,   |       
| |                                    |  |                |       
| |                                    |  | 2005           |        | 2004 |  
| |                                    |  |                |        |      |  
| |                                    |  | (in thousands) |       
| |                                    |  |                |       
| | Cost:                              |  |                |        |      |   |        | 
| |                                    |  |                |        |      |   |        | 
| | Computers and peripheral equipment |  | $              | 8,954  |      | $ | 8,036  | 
| |                                    |  |                |        |      |   |        | 
| | Office furniture and equipment     |  |                | 1,403  |      |   | 1,216  | 
| |                                    |  |                |        |      |   |        | 
| | Leasehold improvements             |  |                | 644    |      |   | 529    | 
| |                                    |  |                |        |      |   |        | 
| | Motor vehicles                     |  |                | 464    |      |   | 833    | 
| |                                    |  |                |        |      |   |        | 
| |                                    |  |                | 11,465 |      |   | 10,614 | 
| |                                    |  |                |        |      |   |        | 
| |                                    |  |                |        |      |   |        | 
| | Accumulated Depreciation:          |  |                |        |      |   |        | 
| |                                    |  |                |        |      |   |        | 
| | Computers and peripheral equipment |  |                | 7,866  |      |   | 6,651  | 
| |                                    |  |                |        |      |   |        | 
| | Office furniture and equipment     |  |                | 872    |      |   | 638    | 
| |                                    |  |                |        |      |   |        | 
| | Leasehold improvements             |  |                | 358    |      |   | 256    | 
| |                                    |  |                |        |      |   |        | 
| | Motor vehicles                     |  |                | 209    |      |   | 376    | 
| |                                    |  |                |        |      |   |        | 
| |                                    |  |                | 9,305  |      |   | 7,921  | 
| |                                    |  |                |        |      |   |        | 
| | Depreciated cost                   |  | $              | 2,160  |      | $ | 2,693  | 
| |                                    |  |                |        |      |   |        | 

| |                                                                                                                                           
| | ------------------------------------------------------------------------------------------------------------------------------------------
| | Depreciation
  expenses totaled $1,058, $1,380, and $1,293 thousand for the years ended
  December 31, 2005, 2004, and 2003, respectively.

F-32

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |          
|-------- | ---------
|Note 5  | Goodwill:

| |                                         |  |                |        |      |   |        | 
| | --------------------------------------- |  | -------------- | ------ | ---- | - | ------ | 
| |                                         |  | December 31,   |       
| |                                         |  |                |       
| |                                         |  | 2005           |        | 2004 |  
| |                                         |  |                |        |      |  
| |                                         |  | (in thousands) |       
| |                                         |  |                |       
| |                                         |  |                |       
| | Carrying amounts at
  beginning of year |  | $              | 37,090 |      | $ | 36,807 | 
| | Acquired                                |  |                | 1,742  |      |   | 283    | 
| |                                         |  |                |        |      |   |        | 
| | Carrying amount at end of year          |  | $              | 38,832 |      | $ | 37,090 | 
| |                                         |  |                |        |      |   |        | 

|         |                                      
|-------- | -------------------------------------
|Note 6  | Software Development Costs and Other:

|   |             
|-- | ------------
|A. | Composition:

| |                                                      |                                   |                |        |        |   |        |        | 
| | ---------------------------------------------------- | --------------------------------- | -------------- | ------ | ------ | - | ------ | ------ | 
| |                                                      |                                   | December 31,   |       
| |                                                      |                                   |                |       
| |                                                      |                                   | 2005           |        | 2004   |  
| |                                                      |                                   |                |        |        |  
| |                                                      |                                   | (in thousands) |       
| |                                                      |                                   |                |       
| |                                                      |                                   |                |       
| | Software development costs
  (2)                     |                                   | $              | 25,810 |        | $ | 21,729 |       
| | Customer related
  intangible assets (3)             |                                   |                | 453    |        |   | 372    |       
| | Deferred issuance
  expenses, net                    |                                   |                | 328    |        |   | 516    |       
| | Rent deposit                                         |                                   |                | 119    |        |   | 176    |       
| | Deferred tax asset                                   |                                   |                | 13     |        |   | 110    |       
| | Loans to others (4)                                  |                                   |                | -      |        |   | 85     |       
| | Secured promissory note to
  other company (Note 3C) |                                   |                | -      |        |   | 97     |       
| | Others                                               |                                   |                | 177    |        |   | 93     |       
| |                                                      |                                   |                |        |        |   |        |       
| |                                                      |                                   | $              | 26,900 |        | $ | 23,178 |       
| |                                                      |                                   |                |        |        |   |        |       
| |                                                      |                                   |                |        |        |   |        |       
| | (2)                                                  | Original amount                   |                | $      | 39,287 |   | $      | 30,143 | 
| |                                                      | Less - accumulated
  amortization |                |        | 13,477 |   |        | 8,414  | 
| |                                                      |                                   |                |        |        |   |        |        | 
| |                                                      |                                   |                | $      | 25,810 |   | $      | 21,729 | 
| |                                                      |                                   |                |        |        |   |        |        | 
| | (3)                                                  | Original amount                   |                | $      | 923    |   | $      | 425    | 
| |                                                      | Less - accumulated
  amortization |                |        | 470    |   |        | 53     | 
| |                                                      |                                   |                |        |        |   |        |        | 
| |                                                      |                                   |                | $      | 453    |   | $      | 372    | 
| |                                                      |                                   |                |        |        |   |        |        | 

| |     |                                                                                                                                                                                              
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |     | As of December 31, 2005,
  amortization of customer related intangible asset amounted to $417 thousand.                                                                                      
| |     |                                                                                                                                                                                              
| |     | The estimated aggregate
  amortization of customer related intangible asset for the following years is
  as follows: 2006 and 2007: $237 thousand, 2008: $113 thousand, 2009: $71
  thousand.
| |     |                                                                                                                                                                                              
| | (4) | The loan is linked to the
  Israeli consumer price index and bears as annual interest rate of 4% (see
  Note 16E).                                                                           

F-33

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                    
|-------- | -----------------------------------
|Note 7  | Short-Term
  Bank Credit and Other:

Composition:

| |                          |  |                          |         |       |      |                |              |   |        |  |   |       | 
| | ------------------------ |  | ------------------------ | ------- | ----- | ---- | -------------- | ------------ | - | ------ |  | - | ----- | 
| |                          |  | Average 
  Interest rate |         |       |      |                |              |  
| |                          |  |                          |         |       |      |                |             
| |                          |  |                          |         |       |      |                | December 31, |  
| |                          |  | December 31,
  2005      |         |       |      |                |             
| |                          |  |                          | Linkage |       | 2005 |                | 2004         |  
| |                          |  |                          |         |       |      |                |              |   |       
| |                          |  | %                        |         | Basis |      | (in thousands) |             
| |                          |  |                          |         |       |      |                |             
|
| | Bank overdraft and loans |  |                          | 7.03    |       |      | NIS            |              | $ | 2,654  |  | $ | 1,532 | 
| | Short-term bank loans    |  |                          | 4.71    |       |      | CPI            |              |   | 12     |  |   | -     | 
| | Short-term bank loans    |  |                          | 5.22    |       |      | Dollar         |              |   | 5,556  |  |   | 5,000 | 
| | Promissory note to FIMI  |  |                          | 5.00    |       |      | Dollar         |              |   | 4,293  |  |   | -     | 
| | Short-term bank loans    |  |                          | 4.13    |       |      | Euro           |              |   | 1,580  |  |   | 682   | 
| |                          |  |                          |         |       |      |                |              |   |        |  |   |       | 
| |                          |  |                          |         |       |      |                |              | $ | 14,095 |  | $ | 7,214 | 
| |                          |  |                          |         |       |      |                |              |   |        |  |   |       | 

|         |                              
|-------- | -----------------------------
|Note 8  | Accrued
  Severance Pay, Net:

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | Accrued Liability:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | The Company is liable for
  severance pay to its employees pursuant to the applicable local laws
  prevailing in the respective countries of employment and employment
  agreements. For Israeli employees, the liability is partially covered by
  individual managers insurance policies under the name of the employee, for
  which the Company makes monthly payments. The Company may make withdrawals
  from the managers insurance policies only for the purpose of paying
  severance pay.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | The amounts accrued and
  the amounts funded with managers insurance policies are as follows:                                                                                                                                                                                                                                                                                                                                                                                                      

| |                       |  |                |       |      |   |       | 
| | --------------------- |  | -------------- | ----- | ---- | - | ----- | 
| |                       |  | December 31,   |      
| |                       |  |                |      
| |                       |  | 2005           |       | 2004 |  
| |                       |  |                |       |      |  
| |                       |  | (in thousands) |      
| |                       |  |                |      
|
| | Accrued severance pay |  | $              | 4,733 |      | $ | 4,493 | 
| | Less - amount funded  |  |                | 3,424 |      |   | 3,333 | 
| |                       |  |                |       |      |   |       | 
| |                       |  | $              | 1,309 |      | $ | 1,160 | 
| |                       |  |                |       |      |   |       | 
| |                       |  |                |       |      |   |       | 

|   |                                                                                                                                                  
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Expenses:                                                                                                                                        
|   |                                                                                                                                                  
|   | The expenses related to
  severance pay for the years ended December 31, 2005, 2004, and 2003 were
  $383, $766, and $720 thousand, respectively.

F-34

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                                            
|-------- | -----------------------------------------------------------
|Note 9  | Provision
  for Losses in Formerly-consolidated Subsidiary:

Liraz is liable for losses
in a subsidiary it had consolidated until the second quarter of 2001. The
provision for such liability as of December 31, 2005 and December 31, 2004, was
accounted for under SFAS No. 5 and amounted to $2 million, representing the
maximum potential amount Liraz has guaranteed to secure a bank loan of the said
subsidiary. Under its terms, such guarantee may be reduced to the extent that
the subsidiary raises additional share capital. The guarantee will be
outstanding until November 2006. In the fourth quarter of 2003, $541 thousand
was recorded as gain due to a repayment of the loan by the
formerly-consolidated subsidiary, which resulted in a decrease by the bank of
the guaranteed amount (see also Note 3C, with respect to the investment in
Level 8).

| |                                        |  |                |       |      |   |       | 
| | -------------------------------------- |  | -------------- | ----- | ---- | - | ----- | 
| |                                        |  | December 31,   |      
| |                                        |  |                |      
| |                                        |  | 2005           |       | 2004 |  
| |                                        |  |                |       |      |  
| |                                        |  | (in thousands) |      
| |                                        |  |                |      
|
| | Carrying amount at
  beginning of year |  | $              | 1,971 |      | $ | 1,971 | 
| | Realization                            |  |                | -     |      |   | -     | 
| |                                        |  |                |       |      |   |       | 
| | Carrying amount at end of year         |  | $              | 1,971 |      | $ | 1,971 | 
| |                                        |  |                |       |      |   |       | 

|          |                               
|--------- | ------------------------------
|Note 10  | Loans
  from Banks and Others:

|   |             
|-- | ------------
|A. | Composition:

| |                       |  |                   |  |                          |        |                    |   |                                                      |     |                                                        |       |       |   |       |      
| | --------------------- |  | ----------------- |  | ------------------------ | ------ | ------------------ | - | ---------------------------------------------------- | --- | ------------------------------------------------------ | ----- | ----- | - | ----- | -----
| | December 31, 2005     |  | December 31, 2005 |  | December 31, 2004        |       
| |                       |  |                   |  |                          |       
| | Average Interest rate |  | Linkage           |  | Long-term 
  liabilities |        | Current 
  portion |   | Total long-termliabilities net of 
  current portion |     | Total long-term
  liabilities net of
  current portion |      
| |                       |  |                   |  |                          |        |                    |   |                                                      |     |                                                        |      
| |                       |  |                   |  |                          |        |                    |   |                                                     
| | %                     |  | Basis             |  | (in thousands)           |        | (in thousands)     |  
| |                       |  |                   |  |                          |        |                    |  
|
| | 6.42                  |  | Dollar            |  | $                        | *3,836 |                    | $ | -                                                    |     | $                                                      | 3,836 |       | $ | 6,090 |      
| | 8.00                  |  | NIS               |  |                          | 1,694  |                    |   | -                                                    |     |                                                        | 1,694 |       |   | 1,416 |      
| | -                     |  | CPI               |  |                          | -      |                    |   | -                                                    |     |                                                        | -     |       |   | 31    |      
| | 4.33                  |  | Euro              |  |                          | *3,214 |                    |   | 355                                                  |     |                                                        | 2,859 |       |   | -     |      
| |                       |  |                   |  |                          |        |                    |   |                                                      |     |                                                        |       |       |   |       |      
| |                       |  |                   |  |                          | $      | 8,744              |   | $                                                    | 355 |                                                        | $     | 8,389 |   | $     | 7,537
| |                       |  |                   |  |                          |        |                    |   |                                                      |     |                                                        |       |       |   |       |      

|  |                                                                                                                                                                                                                 
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|* | The
  loans bear interest based on the LIBOR.                                                                                                                                                                   
|  |                                                                                                                                                                                                                 
|  | In
  connection with certain loan agreements, the Company committed to certain covenants related to its operation
   see Note 11.A.16. As of December
  31, 2005, The Company met all such financial covenants.

F-35

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|         |                                       
|-------- | --------------------------------------
|Note10  | Loans
  from Banks and Others (cont.):

|   |                                                           
|-- | ----------------------------------------------------------
|B. | Long-term Loans from Banks and
  Other Are Due as Follows:

| |                                |  |                |       |      |   |       | 
| | ------------------------------ |  | -------------- | ----- | ---- | - | ----- | 
| |                                |  | December 31,   |      
| |                                |  |                |      
| |                                |  | 2005           |       | 2004 |  
| |                                |  |                |       |      |  
| |                                |  | (in thousands) |      
| |                                |  |                |      
|
| | First year (current
  portion) |  | $              | 355   |      | $ | 104   | 
| | Second year                    |  |                | 2,227 |      |   | 7,482 | 
| | Third year                     |  |                | 4,150 |      |   | 30    | 
| | Fourth year                    |  |                | 2,012 |      |   | 25    | 
| |                                |  |                |       |      |   |       | 
| | Total                          |  | $              | 8,744 |      | $ | 7,641 | 
| |                                |  |                |       |      |   |       | 

|          |                                 
|--------- | --------------------------------
|Note 11  | Commitments
  and Contingencies:

|   |              |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|-- | ------------ | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | Commitments:
|   |              |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   | 1.           | Significant Agreements:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |              |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   |              | In August 1998, the
  Companys subsidiary, Mainsoft Corporation, entered into a Windows
  source-code license agreement with Microsoft, which terminated and superseded
  Mainsofts prior arrangement with Microsoft. In May 2002, the parties entered
  into an amendment to the 1998 Agreement that expanded Mainsoft access to
  certain Microsoft development technologies. Under the terms of the Agreement,
  as amended, Mainsoft continues to have access to specified software code and
  documentation for specified versions of Windows, Windows NT, and Windows XP,
  collectively the Licensed Software. The agreement grants Mainsoft the right
  to distribute the Licensed Software as a component of its Visual development
  kit and runtime products. The Agreement provides for the payment of royalties
  to Microsoft that are based upon the licensing of its Visual MainWin
  products, which include the Licensed Software. The Agreement has a perpetual
  term although it may be terminated earlier under certain circumstances
  including in the event of change of control of either of the parties.

F-36

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                                       
|--------- | --------------------------------------
|Note 11  | Commitments and
Contingencies (cont.):

|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|-- | ---------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | Commitments
  (cont.):
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   | 1.                     | Significant Agreements
  (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|  
|   |                        | In addition, the agreement
  provides that in the event that Mainsoft ceases the active distribution or
  licensing of its Visual MainWin products for more than one year, it will be
  deemed to have granted to Microsoft a worldwide, exclusive, perpetual,
  irrevocable, royalty-free license to its Visual MainWin products.                                                                                                                                                                                                                                 
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                        | The Agreement provides for
  a procedure under which Microsoft may waive the payment of certain royalties
  by Mainsoft relating to specified customers. Upon recording revenue from a
  customer, Mainsoft accrues the royalties due to Microsoft in product cost of
  revenues and often applies for a waiver. Mainsoft recognizes a reduction in
  product cost of revenues when a waiver is approved by Microsoft.                                                                                                                                             
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                        | In December 2003, Mainsoft
  entered into an Independent Contractor Agreement with Microsoft. In
  accordance with this agreement, Microsoft agreed to offset the value of the
  services Mainsoft performed under the Independent Contractor Agreement from
  accrued royalties of up to $1,605 thousand. During the year ended December
  31, 2005, Mainsoft accrued royalties due to Microsoft of $485 thousand, and
  recognized credits (reduction of expenses) related to waivers and to services
  performed of $18 thousand and $52 thousand, respectively.
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                        | During the year ended
  December 31, 2004, Mainsoft accrued royalties due to Microsoft in the amount
  of $325 thousand, and recognized credits (reduction of expenses) related to
  waivers and to services performed of $125 and c $635 thousand, respectively.
  The excess credits over the royalties amount are related to previous years
  royalties.                                                                                                                                                                                                       
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                        | Mainsofts ability to
  develop, sell, and market its Visual MainWin products that use the Licensed
  Software is dependent upon the continued access to the Licensed Software and
  updated additional source code. While Mainsoft believes its relationship with
  Microsoft will continue on acceptable terms, a change in or termination of
  the agreement could prevent Mainsoft from developing and selling certain
  products and materially adversely affect its business, results of operations,
  and financial condition.                              

F-37

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                                         
|--------- | ----------------------------------------
|Note 11  | Commitments
  and Contingencies (cont.):

|   |                       
|-- | ----------------------
|A. | Commitments
  (cont.):

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 1. | Significant Agreements
  (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|
| |    | On
  February 13, 2004 there were public reports that Microsoft source code had
  leaked on the Internet. These reports indicated that the source code
  contained trace references to the Mainsoft servers and personnel. Mainsofts
  management team fully cooperated with local authorities, the FBI, and
  Microsoft in their respective investigations. All parties conducting
  investigations have found no trace of a security breach after that date.
  Although Mainsoft has been notified in 2004 that the investigation has not
  yet been completed, it has not received any update from the FBI since then.
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | 2. | The Company is obligated
  to pay management fees to Formula in an annual amount equal to 3% of the
  revenues, but not more than $180 thousand.                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
| | 3. | The Company rents its
  offices, vehicles and, other equipment under various operating lease
  agreements. Aggregate minimum rental commitments under non-cancelable leases
  as of December 31, 2005 were as follows:                                                                                                                                                                                                                                                                                                                                                                                                    

| |             |  |                   |       |                                  |   |       | 
| | ----------- |  | ----------------- | ----- | -------------------------------- | - | ----- | 
| |             |  | Office Facilities |       | Vehicles, 
  Equipment, andOther |  
| |             |  |                   |       |                                  |  
| |             |  |                   |       |                                  |  
| | Fiscal 2006 |  | $                 | 1,127 |                                  | $ | 1,190 | 
| | Fiscal 2007 |  |                   | 722   |                                  |   | 1,065 | 
| | Fiscal 2008 |  |                   | 548   |                                  |   | 499   | 
| | Fiscal 2009 |  |                   | 220   |                                  |   | -     | 
| | Thereafter  |  |                   | 87    |                                  |   | -     | 
| |             |  |                   |       |                                  |   |       | 
| |             |  | $                 | 2,704 |                                  | $ | 2,754 | 
| |             |  |                   |       |                                  |   |       | 

|   |                                                                                                                                                                                                                                                                                                                                                                            
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|4. | Under agreements between
  the Company and certain of its customers, the Company undertook to provide
  such customers a bank guarantee for the assurance of performance of its
  obligations under its agreements with such customers. As of December 31,
  2005, there are outstanding bank guarantees on behalf of customers in the
  aggregate amount of $229 thousand.
|   |                                                                                                                                                                                                                                                                                                                                                                            
|5. | Through December 31, 2005,
  Mainsoft entered into a grant agreement with the OCS, for the development of
  Visual MainWin for J2EE.                                                                                                                                                                                                                                       
|  
|   | Royalties of 3% are
  payable to the OCS on sales of Visual MainWin for J2EE up to 100% of the
  dollar-linked grant received with regard to funded product.                                                                                                                                                                                                               
|  
|   | The balance of the
  contingent liability relating to the above royalties as of December 31, 2005
  amounted to approximately $1.3 million.                                                                                                                                                                                                                                

F-38

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                                         
|--------- | ----------------------------------------
|Note 11  | Commitments
  and Contingencies (cont.):

|   |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                 
|-- | -------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | Commitments (cont.):
|   |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | 6.                   | As of January 1, 2004 a wholly owned
  subsidiary entered into a grant agreement with the OCS, for the development
  of PowerText. Royalties of 3% are payable to the OCS on sales of PowerText up
  to 100% of the dollar-linked grant received with regard to the funded
  product. The balance of the contingent liability relating to the above
  royalties as of December 31, 2005 amounted to approximately $200 thousand.
|   |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | 7.                   | Through December 31, 2004, MultiConn Technologies
  entered into a grant agreement with the OCS, for the development of
  WS4Legacy, (formerly known as eXperanto). Royalties of 3% are payable to the OCS on sales of WS4Legacy up
  to 100% of the dollar-linked grant received in regard to the funded product.                                                                                                              
|  
|   |                      | The balance of the
  contingent liability relating to the above royalties at December 31, 2005
  amounted to approximately $580 thousand.                                                                                                                                                                                                                                                                                       
|   |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | 8.                   | The
  Company has granted a creditor of Intercomp an option  see Note 2G, 12B2.                                                                                                                                                                                                                                                                                                                                                
|   |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | 9.                   | As
  to a tax assessment issued to the Company  see Note 14K.                                                                                                                                                                                                                                                                                                                                                                  
|   |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | 10.                  | As
  to a guarantee of debt by Liraz  see Note 9.                                                                                                                                                                                                                                                                                                                                                                              
|   |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | 11.                  | Under an agreement
  entered into in 2000, regarding the sale of its integrated IT systems
  activities and outsourcing business in Israel, Liraz is obligated to
  reimburse the buyer for claims related to the activities during the period
  prior to the sale.                                                                                                                                                             
|   |                      |                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | 12.                  | Liraz has a fixed charge
  in favor of a bank, on certain of its assets, as well as a floating charge on
  its entire assets, securing the Companys bank credit line. This credit
  facility also covers guarantees of $2 million in the aggregate that the
  Company extended to a bank relating to the credit line of Level 8 (see Note
  9).                                                                                

F-39

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                                         
|--------- | ----------------------------------------
|Note 11  | Commitments
  and Contingencies (cont.):

|   |                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                        
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ---------------------------------------------------------------------------------------------------------------------------------------
|A. | Commitments
  (cont.):                                                                                                                                                                                                                   
|   |                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   | 13.                                                                                                                                                                                                                                       | In the first quarter of
  2004, the Singapore-Israel Industrial Research and Development Foundation
  agreed to provide a wholly owned subsidiary of the Company together with a
  Company incorporated in Singapore, financing for the development of a Java
  report generator based on legacy text file input. Accordingly, the foundation
  agreed to award the subsidiary up to $100 thousand repayable according to an
  agreed schedule. As of December 31, 2005, the subsidiary received $30
  thousand of the grant. The grant is required to be repaid in installments
  based on sales of the funded product up to the amount of the grant.
|   |                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   | 14.                                                                                                                                                                                                                                       | The
  Companys subsidiary, I-Ter,
  is entitled to funds to developeEasy4Plan product from the Ministry of
  Production in Italy. Easy4Plan is a workflow management tool designed for
  ISO9000 companies. Approximately 30% of the funds are a grant, and the
  balance is an 8-year loan to be repaid by I-Ter. The loan bears a minimal
  annual interest. The development period ends in July 2006. The Company
  anticipates that during 2005 and 2006 I-Ter will receive a total
  aggregate amount of $600 thousand.                                                                                                                         
|   |                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   | 15.                                                                                                                                                                                                                                       | As to a guarantee to banks
  with respect to a loan of Outlook  see Note 2F.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   | 16.                                                                                                                                                                                                                                       | In connection with the
  credit line extended to the Company by Bank Leumi LeIsrael Ltd., Bank
  Discount LeIsrael Ltd, Bank HaPoalim Ltd., and the First International Bank
  Ltd., the Company committed to certain covenants related to its operation
  such as:                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                           | a)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | Maintaining a minimum
  level of shareholders equity of no less than 40% of the Companys total
  assets and no less than $40 million;
|   |                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                        
|   |                                                                                                                                                                                                                                           | b)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | Maintaining a level of
  annual operating income before depreciation and amortization of no less than
  $5 million; and                
|   |                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                        
|   |                                                                                                                                                                                                                                           | c)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     | Maintaining the ratio of
  the Company bank liabilities to current assets, excluding other current
  assets, of no more than 55%.      
|   |                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                        
|   |                                                                                                                                                                                                                                           | As of December 31, 2005,
  the Company met all such financial covenants.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                                                                                                                                                                                                                                           |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |                                                                                                                                        
|   | No liability was recorded
  in the Companys financial statements with respect to the guarantees
  mentioned above, except for the guarantee by Liraz (see Note 9), and the
  guarantee related to the purchase of Outlook  see Note 2F.

F-40

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                                         
|--------- | ----------------------------------------
|Note 11  | Commitments
  and Contingencies (cont.):

|   |                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|-- | -------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Contingencies:
|   |               
|   | 1.             | In July 2003, a former
  Liraz shareholder filed an application with the Tel-Aviv-Jaffa District Court
  to approve a claim filed by him against the Company, as a class action. The
  claim relates to the acquisition of Liraz shares that the Company completed
  in March 2003. The shareholder alleges that the share price that the Company
  paid to Lirazs shareholders in the tender offer and in a subsequent
  mandatory purchase was lower than the fair price of Liraz shares. The maximum
  amount of the claim is approximately $5.8 million in the aggregate. Under
  Israeli law, the courts approval is required for the plaintiff to represent
  all of the shareholders of Liraz who sold their shareholdings to the Company
  pursuant to the tender offer and the mandatory acquisition. The plaintiff has
  applied for such approval in the lawsuit. A preliminary
  hearing is scheduled for June 2006. The Company believes that the allegations against it in this
  proceeding are without merit and intends to vigorously defend the claim and
  contest the allegations made therein.
|   |                |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   | 2.             | We evaluate estimated losses for indemnifications due to product infringement
  under SFAS No. 5, Accounting for Contingencies, as
  interpreted by FIN 45. At this time, it is not possible to determine the maximum potential amount under these indemnification
  agreements due to lack of prior indemnification claims
  and the unique facts and circumstances involved in each
  particular agreement. Such indemnification agreements
  may not be subject to maximum loss clauses. Historically, we have not incurred material costs as a result of obligations under these
  agreements and we have not accrued any liabilities related to
  such indemnification obligations in our financial
  statements.                                                                                                                                                                                                                                                                                                                                                                                             

F-41

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                      
|--------- | ---------------------
|Note 12  | Shareholders Equity:

|   |                  |                                                                                                                                                                                                                                                                                                                   
|-- | ---------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | Share
  Capital:
|  
|   | 1.               | On January 31, 1997,
  3,120,000 ordinary shares of the Company were offered in an initial public
  offering (the IPO) at a price of $7.50 per share. Since the above
  transaction, the Companys shares have been traded in the United States on
  the NASDAQ National Market. Their current symbol is BPHX.
|   |                  |                                                                                                                                                                                                                                                                                                                   
|   | 2.               | On July 22, 1997, 1,200,000
  ordinary shares of the Company were offered in a second public offering, at a
  price of $27.00 per share, of which 600,000 ordinary shares were issued by
  the Company and 600,000 ordinary shares were sold by existing shareholders.                                            

| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 3. | During the years 1998
  through 2002, two subsidiaries of the Company purchased a total of 1,870,565
  the Companys shares for a total consideration of $14.7 million. All of the
  Companys ordinary shares have equal
  voting rights. However, under applicable Israeli law, the shares held by the
  Companys subsidiaries have no voting rights and, therefore, are excluded
  from the number of its outstanding shares. In January
  2006, the Companys subsidiary sold an aggregate of 136,000 of the shares
  held by it to Israeli institutional investors in Israel, for aggregate
  consideration of approximately $560 thousands. In February 2006, the
  Companys subsidiary sold 86,971 shares to Outlook Systems (See note 2.F).
| |    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | 4. | In January 2001, the
  Companys ordinary shares were listed for trading on the Tel Aviv Stock
  Exchange under the Dual Listing arrangement.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      

|   |                |                                                                                                                                                                                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|-- | -------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   | 5.             | In November 2002, the
  Company issued to Lirazs selling shareholders, including Formula, 3,478,624
  ordinary shares, constituting an aggregate of 26% of the Companys
  outstanding share capital  see Note 2C.
|   |                |                                                                                                                                                                                                                     
|B. | Share Options:
|   |               
|   | 1.             | Employee Share Option
Plans:                                                                                                                                                                                        
|   |                |                                                                                                                                                                                                                     
|   |                | a)                                                                                                                                                                                                                   | The 1996 Share Option
Plan:                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                |                                                                                                                                                                                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                |                                                                                                                                                                                                                      | In 1996, the Company adopted
  two option plans. One of these option plans was terminated after all options
  granted under it were exercised. Pursuant to the other 1996 option plan, as
  amended, the Company reserved 3,700,000 ordinary shares for issuance to
  directors, officers, consultants and employees of the Company and its
  subsidiaries. The exercise price of the options granted under the 1996 option
  plan ranges from $2.25 to $10.50.
|   |                |                                                                                                                                                                                                                      |                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                |                                                                                                                                                                                                                      | Under the 1996 option
  plan, unless determined otherwise by the Board, options vest over a
  three-year period from the date of grant and expire 10 years after grant
  date. Unvested options are forfeited upon termination of employment.                                                                                                                                                                                                                  

F-42

---

---



BLUEPHOENIX
SOLUTIONS LTD.

(An
Israeli Corporation)

NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                              
|--------- | -----------------------------
|Note 12  | Shareholders Equity (cont.):

|   |                          |                                        |                                                                                                           
|-- | ------------------------ | -------------------------------------- | ----------------------------------------------------------------------------------------------------------
|B. | Share
  Options (cont.):
|   |                         
|   | 1.                       | Employee
  Share Option Plans (cont.):
|   |                          |                                       
|   |                          | a)                                     | The 1996
  Share Option Plan (cont.):                                                                     
|   |                          |                                        |                                                                                                           
|   |                          |                                        | The following table
  summarizes information about fixed share options outstanding at December 31,
  2005:

| |                                |  |                                                  |  |                                                      |  |                                          |  |                                                     |       |                                          |  |  |           |  |       |  | 
| | ------------------------------ |  | ------------------------------------------------ |  | ---------------------------------------------------- |  | ---------------------------------------- |  | --------------------------------------------------- | ----- | ---------------------------------------- |  |  | --------- |  | ----- |  | 
| |                                |  | Options Outstanding                              |  | Options Exercisable                                  | 
| |                                |  |                                                  |  |                                                      | 
| | Range of 
  Exercise 
  Prices |  | Number 
  Outstanding 
  on December 
  31, 2005 |  | Weighted 
  Average 
  Remaining Contractual 
  Life |  | Weighted 
  Average 
  Exercise 
  Price |  | Number 
  Exercisable 
  on 
  December 
  31, 2005 |       | Weighted 
  Average 
  Exercise 
  Price | 
| |                                |  |                                                  |  |                                                      |  |                                          |  |                                                     |       |                                          | 
| | $                              |  |                                                  |  | Years                                                |  | $                                        |  |                                                     |       | $                                        | 
| |                                |  |                                                  |  |                                                      |  |                                          |  |                                                     |       |                                          | 
|
| | 2.25                           |  |                                                  |  | 416,000                                              |  | 7.25                                     |  |                                                     | 2.25  |                                          |  |  | 166,000   |  | 2.25  |  | 
| | 3.00                           |  |                                                  |  | 106,701                                              |  | 7.50                                     |  |                                                     | 3.00  |                                          |  |  | 106,701   |  | 3.00  |  | 
| | 3.00                           |  |                                                  |  | 150,000                                              |  | 6.50                                     |  |                                                     | 3.00  |                                          |  |  | 150,000   |  | 3.00  |  | 
| | 3.00                           |  |                                                  |  | 80,000                                               |  | 6.09                                     |  |                                                     | 3.00  |                                          |  |  | 26,667    |  | 3.00  |  | 
| | 3.50                           |  |                                                  |  | 70,000                                               |  | 7.50                                     |  |                                                     | 3.50  |                                          |  |  | 70,000    |  | 3.50  |  | 
| | 3.50                           |  |                                                  |  | 19,500                                               |  | 7.75                                     |  |                                                     | 3.50  |                                          |  |  | 6,500     |  | 3.50  |  | 
| | 4.00                           |  |                                                  |  | 200,000                                              |  | 7.83                                     |  |                                                     | 4.00  |                                          |  |  | 150,000   |  | 4.00  |  | 
| | 4.00                           |  |                                                  |  | 150,000                                              |  | 10.00                                    |  |                                                     | 4.00  |                                          |  |  | 150,000   |  | 4.00  |  | 
| | 4.50                           |  |                                                  |  | 39,183                                               |  | 5.50                                     |  |                                                     | 4.50  |                                          |  |  | 39,183    |  | 4.50  |  | 
| | 4.50                           |  |                                                  |  | 63,000                                               |  | 9.67                                     |  |                                                     | 4.50  |                                          |  |  | 63,000    |  | 4.50  |  | 
| | 5.00                           |  |                                                  |  | 37,400                                               |  | 9.83                                     |  |                                                     | 5.00  |                                          |  |  | 37,400    |  | 5.00  |  | 
| | 5.00                           |  |                                                  |  | 434,312                                              |  | 10.00                                    |  |                                                     | 5.00  |                                          |  |  | 434,312   |  | 5.00  |  | 
| | 5.20                           |  |                                                  |  | 139,500                                              |  | 0.75                                     |  |                                                     | 5.20  |                                          |  |  | 139,500   |  | 5.20  |  | 
| | 5.50                           |  |                                                  |  | 13,000                                               |  | 4.83                                     |  |                                                     | 5.50  |                                          |  |  | 13,000    |  | 5.50  |  | 
| | 6.00                           |  |                                                  |  | 28,000                                               |  | 8.00                                     |  |                                                     | 6.00  |                                          |  |  | 28,000    |  | 6.00  |  | 
| | 6.00                           |  |                                                  |  | 143,721                                              |  | 8.42                                     |  |                                                     | 6.00  |                                          |  |  | 143,721   |  | 6.00  |  | 
| | 6.00                           |  |                                                  |  | 150,000                                              |  | 9.67                                     |  |                                                     | 6.00  |                                          |  |  | 150,000   |  | 6.00  |  | 
| | 6.50                           |  |                                                  |  | 311,900                                              |  | 0.21                                     |  |                                                     | 6.50  |                                          |  |  | 311,900   |  | 6.50  |  | 
| | 6.50                           |  |                                                  |  | 2,000                                                |  | 8.00                                     |  |                                                     | 6.50  |                                          |  |  | 2,000     |  | 6.50  |  | 
| | 8.00                           |  |                                                  |  | 80,000                                               |  | 3.50                                     |  |                                                     | 8.00  |                                          |  |  | 80,000    |  | 8.00  |  | 
| | 9.63                           |  |                                                  |  | 43,000                                               |  | 4.25                                     |  |                                                     | 9.63  |                                          |  |  | 43,000    |  | 9.63  |  | 
| | 10.50                          |  |                                                  |  | 88,600                                               |  | 5.25                                     |  |                                                     | 10.50 |                                          |  |  | 88,600    |  | 10.50 |  | 
| |                                |  |                                                  |  |                                                      |  |                                          |  |                                                     |       |                                          |  |  |           |  |       |  | 
| |                                |  |                                                  |  | 2,765,817                                            |  |                                          |  |                                                     |       |                                          |  |  | 2,399,484 |  |       |  | 
| |                                |  |                                                  |  |                                                      |  |                                          |  |                                                     |       |                                          |  |  |           |  |       |  | 

F-43

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                              
|--------- | -----------------------------
|Note 12  | Shareholders Equity (cont.):

|   |                        |                                      |                                                                                                                                                                                                                                                                                                                                                                                                                            | 
|-- | ---------------------- | ------------------------------------ | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | 
|B. | Share Options (cont.):
|   |                        |                                      |                                                                                                                                                                                                                                                                                                                                                                                                                            | 
|   | 1.                     | Employee Share Option Plans (cont.):
|   |                        |                                      |                                                                                                                                                                                                                                                                                                                                                                                                                            | 
|   |                        | b)                                   | Options granted to employees of a subsidiary:                                                                                                                                                                                                                                                                                                                                                                             
|   |                        |                                      |                                                                                                                                                                                                                                                                                                                                                                                                                            | 
|   |                        |                                      | In August 2000, in connection with the purchase of a controlling
  interest in IntraComp Group, the Company granted options to certain employees
  of IntraComp to purchase an aggregate of 125,000 of the Companys ordinary shares
  of which 55,000 were cancelled. The exercise price of the options is $9.625
  per share. All of these options are currently exercisable. The options shall
  expire in August 2010.
|   |                        |                                      |                                                                                                                                                                                                                                                                                                                                                                                                                           
|   |                        |                                      | Data related to the share option plan as of December 31, 2005, 2004
  and 2003 and changes during the years ended on those dates are as follows:                                                                                                                                                                                                                                                                          

| |                                                                   |  |                       |           |                                       |  |                       |  |                                       |           |                       |  |                                       |  |  |           |   |  |      | 
| | ----------------------------------------------------------------- |  | --------------------- | --------- | ------------------------------------- |  | --------------------- |  | ------------------------------------- | --------- | --------------------- |  | ------------------------------------- |  |  | --------- | - |  | ---- | 
| |                                                                   |  | 2005                  |           | 2004                                  |  | 2003                  | 
| |                                                                   |  |                       |           |                                       |  |                       | 
| |                                                                   |  | Number
  of
  Options |           | Weighted
  Average
  Exercise
  Price |  | Number
  of
  Options |  | Weighted
  Average
  Exercise
  Price |           | Number
  of
  Options |  | Weighted
  Average
  Exercise
  Price | 
| |                                                                   |  |                       |           |                                       |  |                       |  |                                       |           |                       |  |                                       | 
| |                                                                   |  |                       |           | $                                     |  |                       |  | $                                     |           |                       |  | $                                     | 
| |                                                                   |  |                       |           |                                       |  |                       |  |                                       |           |                       |  |                                       | 
|
| | Options outstanding at beginning of year                          |  |                       | 2,132,587 |                                       |  | 5.00                  |  |                                       | 2,159,993 |                       |  | 4.99                                  |  |  | 1,347,260 |   |  | 6.56 | 
| | Changes during the year:                                          |  |                       |           |                                       |  |                       |  |                                       |           |                       |  |                                       |  |  |           |   |  |      | 
| | Granted                                                           |  |                       | 834,712   |                                       |  | 4.96                  |  |                                       | 163,721   |                       |  | 6.00                                  |  |  | 923,000   |   |  | 3.03 | 
| | Exercised                                                         |  |                       | (10,299   | )                                     |  | 3.05                  |  |                                       | (33,767   | )                     |  | 3.56                                  |  |  | (35,267   | ) |  | 2.33 | 
| | Forfeited                                                         |  |                       | (191,183  | )                                     |  | 8.04                  |  |                                       | (157,360  | )                     |  | 6.29                                  |  |  | (75,000   | ) |  | 9.46 | 
| |                                                                   |  |                       |           |                                       |  |                       |  |                                       |           |                       |  |                                       |  |  |           |   |  |      | 
| | Options outstanding at end of year                                |  |                       | 2,765,817 |                                       |  | 4.78                  |  |                                       | 2,132,587 |                       |  | 5.00                                  |  |  | 2,159,993 |   |  | 4.99 | 
| |                                                                   |  |                       |           |                                       |  |                       |  |                                       |           |                       |  |                                       |  |  |           |   |  |      | 
| |                                                                   |  |                       |           |                                       |  |                       |  |                                       |           |                       |  |                                       |  |  |           |   |  |      | 
| | Options exercisable at year-end                                   |  |                       | 2,399,484 |                                       |  | 4.78                  |  |                                       | 877,049   |                       |  | 6.08                                  |  |  | 1,233,575 |   |  | 6.04 | 
| |                                                                   |  |                       |           |                                       |  |                       |  |                                       |           |                       |  |                                       |  |  |           |   |  |      | 
| | Weighted-average fair value of options
  granted during the year* |  |                       | 1.47      |                                       |  |                       |  |                                       | 1.71      |                       |  |                                       |  |  | 0.54      |   |  |      | 
| |                                                                   |  |                       |           |                                       |  |                       |  |                                       |           |                       |  |                                       |  |  |           |   |  |      | 

| |   |                                                                                                                                                                                                                                                                                                                                                                                                               
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | * | The fair value of each option granted is estimated on the date of
  grant, using the Black-Scholes option-pricing model with the following
  weighted average assumptions: dividend yield of 0% for all years; expected
  volatility: 2005 - 41%, 2004 - 26%, 2003 - 28%; risk-free interest rate: 2005
  - 3.93%, 2004 - 2.78%, 2003 - 2.10%; and expected life: 2005 - 5.5 years,
  2004 and 2003 - 3 years.

F-44

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                              
|--------- | -----------------------------
|Note 12  | Shareholders Equity (cont.):

|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- | ---------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Share Options (cont.):
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | 1.                     | Employee Share Option Plans (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                        | c)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       | Acceleration:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          | In anticipation of the effects that adoption of SFAS No. 123R would have, and under the Companys management
  belief that in the currently increasing competition in the labor market, an
  acceleration may have a positive effect on employee morale and retention, the Compensation Committee and
  Board of Directors approved and made effective on December 27, 2005 the
  acceleration of several unvested stock options. As a result, 144,990 and
  1,228,997 unvested stock options were accelerated in the Company and in its
  subsidiary, respectively.
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | 2.                     | Options Granted to FIMI:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                        | In January 2001, the Company granted FIMI, a put option to sell to
  the Company promissory notes issued by Intercomp to FIMI in an aggregate
  principal amount of $3.5 million plus interest accrued since January 2001 at
  an annual rate of 5%, which could be paid, subject to FIMIs approval, in the
  form of the Companys ordinary shares. The total outstanding amount of the
  principal and accrued interest as of December 31, 2005 was $4.3 million. In
  August 2003, the terms of FIMIs option were amended, allowing FIMI to
  exercise its option in three installments during June 2004, June 2005, and
  June 2006. In the first quarter of 2006, FIMI completed exercising all three
  installments for cash, and concurrently, reached an agreement with the
  Company for an early repayment for the promissory notes. Accordingly, the
  Company purchased from FIMI the promissory notes for an aggregate amount of
  $4.48 million including interest accrued. As part of the consideration, the
  Company issued to FIMI warrants to purchase 210,000 BluePhoenix ordinary
  shares exercisable until June 30, 2007, at an exercise price of $4.00 per
  share. The fair value of the warrants was $144 thousand at the commitment
  date.

F-45

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                              
|--------- | -----------------------------
|Note 12  | Shareholders Equity (cont.):

|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|-- | ---------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Share Options (cont.):
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | 3.                     | Option Granted to Infinity:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   |                        | In April 2004, Infinity granted the Company a call option to purchase
  its entire holdings in Intercomp, exercisable until April 1, 2006. If the
  Company does not exercise such option, Infinity will have a put option to
  cause the Company to purchase Infinitys entire holdings in Intercomp,
  exercisable during a six-month period commencing in April 1, 2006. If either
  of the options is exercised, the Company shall be obliged to issue to
  Infinity, as consideration for the Intercomps shares, 100,000 of the
  Companys ordinary shares and an additional amount of shares to be calculated
  based on revenues generated from the sale of licenses using Intercomps
  products generated during 3-year period commencing April 1, 2003.
  The Company may, at the Companys option, pay Infinity the cash equivalent of
  such shares, which will be calculated according to the average closing price
  of the Companys shares during the 20 trading days prior to the exercise of
  any of the options.
  The put and call options with Infinity were accounted for as combined
  instruments under the guidance of EITF 02-02, When Certain Contracts That
  Meet the Definition of Financial Instruments Should Be Combined for
  Accounting Purpose. The combined instruments (synthetic forwards) were
  accounted in accordance with EITF 00-6 Accounting for Freestanding
  Derivative Financial Instruments Indexed to, and Potentially Settled in, the
  Stock of a consolidated Subsidiary and SAFS 150 Accounting for Certain
  Financial Instruments with Characteristics of Both Liabilities and Equity.
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   | 4.                     | Convertible Debentures and Warrants:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
|   |                        | On March 30, 2004, the Company completed a $5 million private
  placement of convertible debentures and warrants to four institutional
  investors. On February 18, 2005, the institutional investors and the Company
  amended certain terms of this transaction.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       

F-46

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                              
|--------- | -----------------------------
|Note 12  | Shareholders Equity (cont.):

|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|-- | ---------------------- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Share Options (cont.):
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   | 4.                     | Convertible Debentures and Warrants (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                        | Pursuant to the amended agreement, the debentures are due in 2007 and
  bear interest at a rate equal to the six-month LIBOR, paid quarterly in cash
  or in a number of BluePhoenix ordinary shares, at the Companys discretion.
  The debentures are convertible into BluePhoenixs ordinary shares at a
  conversion rate of $5.25 per ordinary share, subject to (i) adjustment for
  stock dividends, stock splits, recapitalization and other similar events, and
  (ii) anti-dilution adjustments. Following an event of adjustment in January
  2006, the conversion rate of the debentures was adjusted to$5.24 per ordinary
  share. The conversion rate with respect to payments of interest on the
  debentures will be equal to 90% of the volume weighted average price of
  BluePhoenix ordinary shares on the NASDAQ National market during the 20
  trading days preceding the date of payment of interest. In the event that the
  volume weighted average price per ordinary share (as calculated in the
  preceding sentence) for any 20 consecutive trading days exceeds $6.55, the
  Company may force the holders of the debentures to convert any or all of the
  principal amount of the debentures held by them as of such date, subject to,
  among other things, the Company having an effective resale registration
  statement at such time for the resale of the ordinary shares underlying the
  debentures. In addition to the debentures, the institutional investors were
  issued warrants to purchase up to 285,714 BluePhoenix ordinary shares at an
  exercise price of $6.50 per share, subject to adjustments similar to those
  pertaining to the conversion price of the debentures. The warrants are
  exercisable during a 5-year period commencing September 2004.
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                        | Pursuant to the Companys agreement with the institutional investors, in March 2006, three of the investors
exercised their right to purchase additional debentures and warrants. Accordingly, the Company issued to the
investors debentures at an aggregate purchase price of $3 million on the same terms as the initial debentures,
except that the conversion price is $4.50 per share and due in 2009. In addition, the institutional investors
were issued additional warrants on the same terms as the initial warrants, to purchase an aggregate of up to
200,000 BluePhoenix ordinary shares. The warrants are exercisable during a 5-year period commencing in September
2006. Under the agreement with the institutional investors, the Company is obligated to file a registration
statement on Form F-3 within 45 days from the closing, and the registration statement is required to be declared
effective within 90 days after the Compant files it (or 120 days in the event of a review by the SEC).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          

If the
additional debentures issued to the institutional investors are fully converted,
the applicable interest is paid in cash, and the additional warrants are fully
exercised, the Company would be required to issue to the investors up to
866,667 ordinary shares, subject to adjustments.

F-47

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                              
|--------- | -----------------------------
|Note 12  | Shareholders Equity (cont.):

|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|-- | ---------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Share Options (cont.):
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   | 4.                     | Convertible Debentures and Warrants (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
|   |                        | In accordance with APB No. 14, Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants,
EITF 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable
Conversion Rations, and EITF 00-27, Application of Issue No. 98-5 to Certain Convertible Instruments (EITF
00-27), a portion of the proceeds of the convertible debentures issued with detachable warrants was allocated to
the warrants and to the convertible instrument at the time of issuance. Amounts allocated to the warrants were
accounted for as liabilities, in accordance with EITF 00-19, Accounting for Derivative Financial Instruments
Indexed to, and Potentially Settled In, a Companys Own Stock, and were revalued, based on the fair values of
the underlying shares, on each reporting date, against financial expenses (income). The financial expenses
relating to the change in the value of the warrants derivative amounted $104 thousand and $45 thousand for the
years ended 2004 and 2005, respectively.

F-48

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                              
|--------- | -----------------------------
|Note 12  | Shareholders Equity (cont.):

|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- | ---------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Share Options (cont.):
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | 4.                     | Convertible Debentures and Warrants (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                        | Since any future dilutive issuance is under the control of the
  Company, and the anti-dilution adjustment is limited, the Company treated the
  debentures as a conventional convertible instruments.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                        | As a result, a beneficial conversion feature was recorded on the
  debentures, in the amount of $173 thousand, since the effective conversion
  price of the debentures was lower than the fair value of the shares on the
  commitment date.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                        | The Company applied EITF 96-19 Debtors Accounting for a
  Modification or Exchange of Debt Instruments and EITF 05-7 Accounting of
  Modification to Conversion Option Embedded in Debt Securities and Related
  Issues to determine the accounting for the modification on February 18,
  2005. The change in the term of the convertible debentures was accounted for
  as a modification of the instrument as a result of the application of the 10%
  test on the modified debenture and the original debenture. As a result the
  change in the debt instrument is not considered substantially different (less
  then 10%).                                                                                                                                                                              
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                        | A new effective interest rate was determined based on the carrying
  amount of the original debt instrument and the revised cash flows. The deemed
  discount of the debentures is deducted from the liability and the issuance
  expenses, which are recorded as an asset, and is amortized using the interest
  method over a period of 44 months, the term of the debentures.                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                        | The difference between the fair value of the conversion option
  immediately following such modification and the fair value immediately prior
  to the modification was recognized as a discount associated with the debt and
  the offset to the discount was recognized in equity in accordance with EITF
  05-7 in the amount of $325 thousand. The difference between the fair value of
  the modified warrants and the fair value of the original warrants (the
  warrants are revaluated based on the fair values of the underling shares) was
  deducted from the warrant derivative against a discount. The financial
  expense relating to the amortization of the discount of the debentures
  amounted to $217 thousand and $276 thousand for the years ended December 31,
  2004 and 2005, respectively.

F-49

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                              
|--------- | -----------------------------
|Note 12  | Shareholders Equity (cont.):

|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|-- | ---------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Share Options (cont.):
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   | 4.                     | Convertible Debentures and Warrants (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   |                        | On March 15, 2005, as the Form F-3 relating to the convertible debentures
  was declared effective by the Securities Exchange Commission, the Company
  classified the fair value attributed to the warrants as equity. The warrants
  were revaluated to their fair value until such date.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   | 5.                     | In February 2006, the Company completed an underwritten public
  offering in Israel of series A convertible notes in an aggregate principal
  amount of $11.5 million. The price of the notes as determined in the offering
  was 98% of the principal amount of the notes, and the gross proceeds from the
  offering of the notes totaled $11.2 million. The notes bear an interest at a
  rate of LIBOR 3 months +1.5% per annum, payable every 3 months beginning on
  May 1, 2006, with the last payment to be made on February 1, 2011. The
  principal of the notes is payable in four equal annual installments on
  February 1 of each of 2008 through 2011. Under certain terms, the Company may
  call for an early redemption of the notes, after February 1, 2008. The notes
  are convertible into ordinary shares of BluePhoenix at a conversion rate of
  one ordinary share per $5.52 principal amount of notes, subject to
  adjustments. Holders may convert their notes into BluePhoenix ordinary shares
  on any trading day, beginning on the date the notes were first listed for
  trading until the closing of trade on January 16, 2011, except for certain
  specified days. The convertible notes are not secured.
|   |                        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
|   |                        | The notes are traded on the TASE. The Israeli Securities Authority
  and the TASE approved the listing of the shares underlying the notes for trading
  on the TASE. The notes and the shares underlying the notes have not been
  registered under the Securities Act, and may not be offered or sold in the
  United States or to U.S. persons, absent registration or an applicable
  exemption from registration requirements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            

F-50

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                              
|--------- | -----------------------------
|Note 12  | Shareholders Equity (cont.):

|   |                        |                                                                                                                                                                                                                                                                                                          
|-- | ---------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Share Options (cont.):
|   |                        |                                                                                                                                                                                                                                                                                                          
|   | 6.                     | Employee Option Plans in a Subsidiary:                                                                                                                                                                                                                                                                   
|   |                        |                                                                                                                                                                                                                                                                                                          
|   |                        | A subsidiary granted options to its employees to purchase the
  subsidiarys shares. The options are exercisable during a 3-year period after
  the date of grant. A summary of the status of the option plans as of December
  31, 2005 and 2004 and changes during the years then ended is given below:

| |                                                                    |  |                     |           |                                       |      |                     |  |                                       |        |      |      |  | 
| | ------------------------------------------------------------------ |  | ------------------- | --------- | ------------------------------------- | ---- | ------------------- |  | ------------------------------------- | ------ | ---- | ---- |  | 
| |                                                                    |  | 2005                |           | 2004                                  |     
| |                                                                    |  |                     |           |                                       |     
| |                                                                    |  | Number of
  Options |           | Weighted
  Average
  Exercise
  Price |      | Number of
  Options |  | Weighted
  Average
  Exercise
  Price |       
| |                                                                    |  |                     |           |                                       |      |                     |  |                                       |       
| |                                                                    |  |                     |           | $                                     |      |                     |  | $                                     |       
| |                                                                    |  |                     |           |                                       |      |                     |  |                                       |       
| | Options outstanding at beginning of year                           |  |                     | 4,463,487 |                                       | 0.97 |                     |  | 3,694,237                             |        | 0.74 |     
| | Changes during the year:                                           |  |                     |           |                                       |      |                     |  |                                       |        |      |      |  | 
| | Granted                                                            |  |                     | 426,000   |                                       | 0.65 |                     |  | 1,281,500                             |        | 0.65 |     
| | Exercised                                                          |  |                     | -         |                                       |      |                     |  |                                       | (4,790 | )    | 1.75 | 
| | Forfeited/cancelled                                                |  |                     | (210,000  | )                                     | 0.85 |                     |  | (507,460                              | )      | 0.75 |     
| |                                                                    |  |                     |           |                                       |      |                     |  |                                       |        |      |      |  | 
| | Options outstanding at end of year                                 |  |                     | 4,679,487 |                                       | 0.84 |                     |  | 4,463,487                             |        | 0.97 |     
| |                                                                    |  |                     |           |                                       |      |                     |  |                                       |        |      |      |  | 
| | Options exercisable at year-end                                    |  |                     | 4,679,487 |                                       | 0.84 |                     |  | 2,547,776                             |        | 0.85 |     
| |                                                                    |  |                     |           |                                       |      |                     |  |                                       |        |      |      |  | 
| | Weighted-average fair value of options
  granted during the year * |  |                     | 0.22      |                                       |      |                     |  |                                       | 0.08   |      |      |  | 
| |                                                                    |  |                     |           |                                       |      |                     |  |                                       |        |      |      |  | 

| |                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                      
| | -------------------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | *                                                                                                        | The fair value of each option granted is estimated on the date of
  grant, using the Black-Scholes option-pricing model with the following
  weighted average assumptions: dividend yield of 0% for all years; expected
  volatility: 2005 - 44%, 2004 - 0.1%; risk-free interest rate: 2005 - 3.93%,
  and 2004 - 3.43%; and expected life: 2005 and 2004 - 3 years.
| |                                                                                                          |                                                                                                                                                                                                                                                                                                                                                                      
| | The following table summarizes information about fixed share options
  outstanding at December 31, 2005:

| |                                |  |                                               |           |                                                 |       |                                       |  |                                               |  |                                       |           |           |      |  |  | 
| | ------------------------------ |  | --------------------------------------------- | --------- | ----------------------------------------------- | ----- | ------------------------------------- |  | --------------------------------------------- |  | ------------------------------------- | --------- | --------- | ---- |  |  | 
| |                                |  | Options Outstanding                           |           | Options Exercisable                             |      
| |                                |  |                                               |           |                                                 |      
| | Range
  of
  Exercise
  Prices |  | Number
  Outstanding
  at December
  31, 2005 |           | Weighted Average
  Remaining
  Contractual Life |       | Weighted
  Average
  Exercise
  Price |  | Number
  Exercisable
  at December
  31, 2005 |  | Weighted
  Average
  Exercise
  Price |          
| |                                |  |                                               |           |                                                 |       |                                       |  |                                               |  |                                       |          
| | $                              |  |                                               |           | Years                                           |       | $                                     |  |                                               |  | $                                     |          
| |                                |  |                                               |           |                                                 |       |                                       |  |                                               |  |                                       |          
| | 0.10.50                       |  |                                               | 793,421   |                                                 | 10.45 |                                       |  | 0.26                                          |  |                                       | 793,421   |           | 0.26 | 
| | 0.65                           |  |                                               | 2,759,673 |                                                 | 7.45  |                                       |  | 0.65                                          |  |                                       | 2,759,673 |           | 0.65 | 
| | 0.752.5                       |  |                                               | 1,126,393 |                                                 | 17.1  |                                       |  | 1.72                                          |  |                                       | 1,126,393 |           | 1.72 | 
| |                                |  |                                               |           |                                                 |       |                                       |  |                                               |  |                                       |           |           |      |  |  | 
| |                                |  |                                               | 4,679,487 |                                                 |       |                                       |  |                                               |  |                                       |           | 4,679,487 |      |  |  | 
| |                                |  |                                               |           |                                                 |       |                                       |  |                                               |  |                                       |           |           |      |  |  | 

F-51

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                              
|--------- | -----------------------------
|Note 12  | Shareholders Equity (cont.):

|   |            |                                                                                                                                                                                                                                                                                                                                     
|-- | ---------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|C. | Dividends:
|   |            |                                                                                                                                                                                                                                                                                                                                     
|   | 1.         | The Company has not paid any cash dividends on its ordinary shares in
  the past and does not expect to pay cash dividends on its ordinary shares in
  the foreseeable future.                                                                                                                                                      
|   |            |                                                                                                                                                                                                                                                                                                                                     
|   | 2.         | As described in Note 14A, in the event of a distribution of cash
  dividends in the amount of approximately $16.4 million out of retained
  earnings, regarding which the Company was tax exempt due to the Approved
  Enterprise status of its approved operations, the Company would have to pay
  a 25% tax on the said amount.

|          |                                          
|--------- | -----------------------------------------
|Note 13  | Monetary Balances in Non-dollar Currency:

|                                  |  |                |        |      |   |        |  | 
|--------------------------------- |  | -------------- | ------ | ---- | - | ------ |  | 
|                                  |  | December 31,   |        |     
|                                  |  |                |        |     
|                                  |  | 2005           |        | 2004 |   |       
|                                  |  |                |        |      |   |       
|                                  |  | (in thousands) |        |     
|                                  |  |                |        |     
|                                 
|ASSETS:                           |  |                |        |      |   |        |  | 
|Current assets                    |  | $              | 16,128 |      | $ | 14,554 |  | 
|Long-term assets                  |  |                | 58     |      |   | 542    |  | 
|                                  |  |                |        |      |   |        |  | 
|                                  |  |                | 16,186 |      |   | 15,096 |  | 
|                                  |  |                |        |      |   |        |  | 
|LIABILITIES:                      |  |                |        |      |   |        |  | 
|Current liabilities               |  |                | 11,984 |      |   | 13,031 |  | 
|Long-term liabilities             |  |                | 4,684  |      |   | 1,934  |  | 
|                                  |  |                |        |      |   |        |  | 
|                                  |  |                | 16,668 |      |   | 14,965 |  | 
|                                  |  |                |        |      |   |        |  | 
|                                  |  |                |        |      |   |        |  | 
|Net monetary assets (liabilities) |  | $              | (482   | )    | $ | 131    |  | 
|                                  |  |                |        |      |   |        |  | 

|          |                 
|--------- | ----------------
|Note 14  | Taxes on Income:

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | Tax Benefits Under the Israeli Law for the Encouragement of Capital
  Investments, 1959 (hereafter - the Law):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   | Some operations of BluePhoenix and certain subsidiaries (BluePhoenix
  and the Subsidiaries) have been granted Approved Enterprise status under
  the Law. Since BluePhoenix and the Subsidiaries have elected to receive
  alternative benefits under the Law (i.e., waiver of grants in exchange for
  a tax exemption for a limited period), the following tax rates will apply to
  its income from the Approved Enterprise (which will be determined based on
  the increase in the revenue of BluePhoenix or the Subsidiaries during the
  year, in relation to the revenue in the year preceding the first year of
  their having the above-mentioned status):

F-52

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                         
|--------- | ------------------------
|Note 14  | Taxes on Income (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|-- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|A. | (cont.):                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | Tax exemption for 2 years, commencing the first year it generates
  taxable income. For the remainder of the benefit period of 5 years, a reduced
  tax rate of 25% is applicable.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | The entitlement to the above benefits is subject to final
  ratification by the Investment Center of the Ministry of Industry and Trade, such
  ratification being conditional upon fulfillment of all terms of the approved
  program.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | In the event of distribution of a cash dividend out of retained
  earnings that were tax exempt due to the above benefits, BluePhoenix would
  have to pay approximately $4.1 million tax with respect to the amount
  distributed (see Note 12C). The Company has determined that it will not
  distribute any amounts of its undistributed tax exempt income as dividend.
  The Company intends to reinvest the amount of its tax-exempt income.
  Accordingly, no deferred income taxes have been provided on income
  attributable to the Companys Approved Enterprise as the undistributed tax
  exempt income is essentially permanent in duration.                                                                                                                                                                                                                                                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | The Law also provides that an Approved Enterprise is entitled to
  accelerated depreciation on its property and equipment that is included in an
  approved investment program.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | In the event BluePhoenix or the Subsidiaries fail to comply with the
  approved program terms, the tax benefits may be canceled and BluePhoenix or
  the Subsidiaries may be required to refund the amount of the benefits they
  utilized, in whole or in part, with the addition of linkage differences and
  interest.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | Income from sources other than the Approved Enterprise is subject
  to tax at regular Israeli corporate tax rate.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
|   | On April 1, 2005, an amendment to the Investment Law came into effect
  (the Amendment) and has significantly changed the provisions of the
  Investment Law. The Amendment limits the scope of enterprises that may be
  approved by the Investment Center by setting criteria for the approval of a
  facility as a Privileged Enterprise, such as provisions generally requiring
  that at least 25% of the Privileged Enterprises income will be derived from
  export. Additionally, the Amendment enacted major changes in the manner in
  which tax benefits are awarded under the Investment Law so that companies no
  longer require Investment Center approval in order to qualify for tax
  benefits. In addition, the Investment Law provides that terms and benefits
  included in any certificate of approval already granted will remain subject
  to the provisions of the law as they were on the date of such approval.
  Therefore, BluePhoenixs existing Approved Enterprise status will generally
  not be subject to the provisions of the Amendment.

F-53

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                         
|--------- | ------------------------
|Note 14  | Taxes on Income (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|-- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Measurement of Results for Tax Purposes Under the Income Tax
  (Inflationary Adjustments) Law, 1985 (hereafter - the Inflationary
  Adjustments Law):                                                                                                                                                                                                                                                                                                                                                            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   | Under this
  law, results for tax purposes are adjusted based on the changes in the
  exchange rate of the U.S. dollar against the NIS.                                                                                                                                                                                                                                                                                                                                                                            
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|C. | Tax Benefits Under the Law for the Encouragement of Industry
  (Taxation), 1969:                                                                                                                                                                                                                                                                                                                                                                                                                                   
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   | The Company
  currently qualifies as an Industrial Company as defined by this law, and as
  such is entitled to certain tax benefits including, inter alia, depreciation
  at increased rates as stipulated by regulations published under the
  Inflationary Adjustments Law and has the right to deduct for tax purposes,
  over a period of 3 years, expenses relating to public issuance of shares. If
  realized, any tax benefit relating to issuance expenses is credited to
  additional paid-in capital.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|D. | Tax Rate Applicable to Income in Israel:                                                                                                                                                                                                                                                                                                                                                                                                                                                                           
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   | On July 25,
  2005, the Law for Amendment of the Income Tax Ordinance (Amendment No. 147)
  became effective. Pursuant to this amendment, the income tax applicable to Israeli
  companies will be gradually reduced from 34% in 2005 to 25% in 2010 and
  henceforth. This tax rate decrease is not expected to have a material effect
  on the Companys financial position. The Company is evaluating the existence
  of additional impacts of this Amendment.                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|E. | Deferred Income Taxes:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
|   | Deferred tax
  assets reflect the net tax effects of temporary differences between the
  carrying amounts of assets or liabilities for financial reporting purposes
  and the amounts used for income tax purposes. As of December 31, 2004 and
  2005 the Companys deferred taxes were in respect of the following:                                                                                                                                                                                              

| |                                                                  |  |                |         |      |   |         |   | 
| | ---------------------------------------------------------------- |  | -------------- | ------- | ---- | - | ------- | - | 
| |                                                                  |  | December 31,   |         |     
| |                                                                  |  |                |         |     
| |                                                                  |  | 2005           |         | 2004 |   |        
| |                                                                  |  |                |         |      |   |        
| |                                                                  |  | (in thousands) |         |     
| |                                                                  |  |                |         |     
| | Net operating losses carry forwards                              |  | $              | 25,034  |      | $ | 24,704  |   | 
| | Software development costs                                       |  |                | 1,566   |      |   | 1,065   |   | 
| | Provisions for employee rights and other
  temporary differences |  |                | 735     |      |   | 412     |   | 
| |                                                                  |  |                |         |      |   |         |   | 
| |                                                                  |  |                | 27,335  |      |   | 26,181  |   | 
| | Valuation allowance                                              |  |                | (27,311 | )    |   | (26,099 | ) | 
| |                                                                  |  |                |         |      |   |         |   | 
| |                                                                  |  | $              | 24      |      | $ | 82      |   | 
| |                                                                  |  |                |         |      |   |         |   | 

| |   |                                                                                                                                                                
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------
| | * | The
  Companys management cannot determine whether it is more likely than not that
  the deferred tax asset relating to net operating losses will be realized.

F-54

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                         
|--------- | ------------------------
|Note 14  | Taxes on Income (cont.):

|   |                                                                                                                   | 
|-- | ----------------------------------------------------------------------------------------------------------------- | 
|F. | Non-Israeli Subsidiaries:                                                                                        
|   |                                                                                                                   | 
|   | Non-Israeli
  subsidiaries are taxed based upon tax laws in the country of domicile of the respective subsidiary.
|   |                                                                                                                   | 
|G. | Income Before Taxes on Income is Composed as Follows:                                                            

| |                     |  |                         |        |      |   |        |   |   |        |  
| | ------------------- |  | ----------------------- | ------ | ---- | - | ------ | - | - | ------ | -
| |                     |  | Year ended December 31, |       
| |                     |  |                         |       
| |                     |  | 2005                    |        | 2004 |   | 2003   |  
| |                     |  |                         |        |      |   |        |  
| |                     |  | (in thousands)          |       
| |                     |  |                         |       
|
| | Domestic
  (Israel) |  | $                       | (1,560 | )    | $ | (5,097 | ) | $ | (4,665 | )
| | Foreign             |  |                         | 3,637  |      |   | 8,792  |   |   | 7,720  |  
| |                     |  |                         |        |      |   |        |   |   |        |  
| |                     |  | $                       | 2,077  |      | $ | 3,695  |   | $ | 3,055  |  
| |                     |  |                         |        |      |   |        |   |   |        |  

|   |                                                      
|-- | -----------------------------------------------------
|H. | Taxes on Income Included in the Statements of Income:

| |                                    |  |                         |     |      |   |      |   |   |      |  
| | ---------------------------------- |  | ----------------------- | --- | ---- | - | ---- | - | - | ---- | -
| |                                    |  | Year ended December 31, |    
| |                                    |  |                         |    
| |                                    |  | 2005                    |     | 2004 |   | 2003 |  
| |                                    |  |                         |     |      |   |      |  
| |                                    |  | (in thousands)          |    
| |                                    |  |                         |    
|
| | For the
  reported year - current: |  |                         |     |      |   |      |   |   |      |  
| | Domestic
  (Israel)                |  | $                       | 8   |      | $ | 15   |   | $ | 8    |  
| | Foreign                            |  |                         | 164 |      |   | 98   |   |   | 411  |  
| |                                    |  |                         |     |      |   |      |   |   |      |  
| |                                    |  |                         | 172 |      |   | 113  |   |   | 419  |  
| | Taxes
  related to prior years     |  |                         | (81 | )    |   | (133 | ) |   | (780 | )
| | Deferred
  taxes, net              |  |                         | 58  |      |   | 280  |   |   | 513  |  
| |                                    |  |                         |     |      |   |      |   |   |      |  
| |                                    |  | $                       | 149 |      | $ | 260  |   | $ | 152  |  
| |                                    |  |                         |     |      |   |      |   |   |      |  

F-55

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                         
|--------- | ------------------------
|Note 14  | Taxes on Income (cont.):

|   |                                                                                                                                               
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------
|I. | A reconciliation of the theoretical tax expense, assuming all income
  is taxed at the regular rates and the actual tax expense is as follows:

| |                                                                                                       |  |                |       |      |   |       |   |   |       |  
| | ----------------------------------------------------------------------------------------------------- |  | -------------- | ----- | ---- | - | ----- | - | - | ----- | -
| |                                                                                                       |  | December 31,   |      
| |                                                                                                       |  |                |      
| |                                                                                                       |  | 2005           |       | 2004 |   | 2003  |  
| |                                                                                                       |  |                |       |      |   |       |  
| |                                                                                                       |  | (in thousands) |      
| |                                                                                                       |  |                |      
| | Income before taxes on income, per
  consolidated statements of income                                |  | $              | 2,077 |      | $ | 3,695 |   | $ | 3,055 |  
| |                                                                                                       |  |                |       |      |   |       |   |   |       |  
| | Theoretical tax expense (36% in 2003, 35%
  in 2004, and 34% in 2005)                                 |  |                | 706   |      |   | 1,293 |   |   | 1,100 |  
| | Tax benefit arising from exempt tax rate as
  an Approved Enterprise                                |  |                | -     |      |   | -     |   |   | -     |  
| |                                                                                                       |  |                |       |      |   |       |   |   |       |  
| |                                                                                                       |  |                | 706   |      |   | 1,293 |   |   | 1,100 |  
| | Decrease in taxes resulting from permanent
  differences:                                             |  |                |       |      |   |       |   |   |       |  
| | State income tax, net of federal benefit                                                              |  |                | (67   | )    |   | 8     |   |   | 12    |  
| | Tax exempt income                                                                                     |  |                | -     |      |   | (246  | ) |   | (222  | )
| | Non-deductible expenses                                                                               |  |                | 282   |      |   | 70    |   |   | 270   |  
| | Effect of different tax rates in foreign
  subsidiaries                                               |  |                | (105  | )    |   | -     |   |   | -     |  
| | Taxes related to previous years                                                                       |  |                | (81   | )    |   | (133  | ) |   | (780  | )
| | Carry-forward losses and research and
  development costs for which the Company provided an allowance |  |                | (649  | )    |   | (432  | ) |   | (296  | )
| | Other                                                                                                 |  |                | 63    |      |   | (300  | ) |   | 68    |  
| |                                                                                                       |  |                |       |      |   |       |   |   |       |  
| | Taxes on income in the consolidated
  statements of income - for the reported year                    |  | $              | 149   |      | $ | 260   |   | $ | 152   |  
| |                                                                                                       |  |                |       |      |   |       |   |   |       |  
| | Effective tax rate                                                                                    |  |                | 7     | %    |   | 7     | % |   | 5     | %
| |                                                                                                       |  |                |       |      |   |       |   |   |       |  

F-56

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                         
|--------- | ------------------------
|Note 14  | Taxes on Income (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|J. | Tax Losses:                                                                                                                                                                                                                                                                                                                                                                                                
|   |                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | 1.                                                                                                                                                                                                                                                                                                                                                                                                          | A U.S. subsidiary has net operating losses (NOL) carry forwards for
  federal tax purposes as of December 31, 2005 totaling $20 million, all of
  which will expire through 2021. That subsidiary has net operating losses
  carry forwards for state tax purposes of $4 million, which expire through
  2013.                                                                                                                                                                                    
|   |                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   |                                                                                                                                                                                                                                                                                                                                                                                                             | In addition, that subsidiary has research and development tax credit
  carry-forwards of approximately $416,000 for Federal income tax purposes and
  $124,000 for California tax purposes as of December 31, 2005. The research
  and development tax credit carry-forwards expire at various times through
  2012. The subsidiary also has alternative minimum tax credit carry-forwards
  of approximately $416,000 for Federal income tax purposes, which may be
  carried forward indefinitely.
|   |                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | 2.                                                                                                                                                                                                                                                                                                                                                                                                          | The Company and its subsidiaries in Israel have NOL carry forwards
  for income tax purposes as of December 31, 2005 totaling $40 million.                                                                                                                                                                                                                                                                                                                                                          
|   |                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|K. | Tax Assessments:                                                                                                                                                                                                                                                                                                                                                                                           
|   |                                                                                                                                                                                                                                                                                                                                                                                                             |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|   | The Company received a revised tax assessment for the 19972001 tax
  years at a total amount of approximately $1.2 million. The Company paid a
  down payment of approximately $1 million. The Company applied for a final
  settlement of its debts. This tax expense is fully offset against previously
  existing tax reserves (the tax reserve is included in accounts payable and
  accrual  other).

F-57

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                                               
|--------- | ----------------------------------------------
|Note 15  | Supplementary Financial Statement Information:

|   |                 |                            
|-- | --------------- | ---------------------------
|A. | Balance Sheets:
|   |                 |                            
|   | 1.              | Trade
Accounts Receivables:

| |                                        |  |                |        |      |   |        |  
| | -------------------------------------- |  | -------------- | ------ | ---- | - | ------ | -
| |                                        |  | December 31,   |       
| |                                        |  |                |       
| |                                        |  | 2005           |        | 2004 |  
| |                                        |  |                |        |      |  
| |                                        |  | (in thousands) |       
| |                                        |  |                |       
| |                                        |  |                |       
| | Trade
  accounts receivable            |  | $              | 18,824 |      | $ | 16,989 |  
| | Less
  provision for doubtful accounts |  |                | (681   | )    |   | (1,175 | )
| |                                        |  |                |        |      |   |        |  
| |                                        |  | $              | 18,143 |      | $ | 15,814 |  
| |                                        |  |                |        |      |   |        |  

| |     |                                                                                                                                                     
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------
| | (*) | In February
  2004, the Company and a customer mutually agreed to terminate a contract. As
  a result, the Company recorded a loss of $400 thousand.

| |    |                      
| | -- | ---------------------
| | 2. | Other Current Assets:

| |                                      |  |                |       |      |   |       | 
| | ------------------------------------ |  | -------------- | ----- | ---- | - | ----- | 
| |                                      |  | December 31,   |      
| |                                      |  |                |      
| |                                      |  | 2005           |       | 2004 |  
| |                                      |  |                |       |      |  
| |                                      |  | (in thousands) |      
| |                                      |  |                |      
| | Government departments and agencies  |  | $              | 545   |      | $ | 392   | 
| | Advances to suppliers and others     |  |                | 332   |      |   | 193   | 
| | Employees                            |  |                | 132   |      |   | 49    | 
| | Prepaid expenses                     |  |                | 1,000 |      |   | 1,249 | 
| | Related parties                      |  |                | 12    |      |   | 235   | 
| | Short-term lease deposits            |  |                | 273   |      |   | 268   | 
| | Interest and other income receivable |  |                | 201   |      |   | 181   | 
| |                                      |  |                |       |      |   |       | 
| |                                      |  | $              | 2,495 |      | $ | 2,567 | 
| |                                      |  |                |       |      |   |       | 

| |    |                                       
| | -- | --------------------------------------
| | 3. | Accounts Payable and Accruals  Other:

| |                                                  |  |                |       |      |   |       | 
| | ------------------------------------------------ |  | -------------- | ----- | ---- | - | ----- | 
| |                                                  |  | December 31,   |      
| |                                                  |  |                |      
| |                                                  |  | 2005           |       | 2004 |  
| |                                                  |  |                |       |      |  
| |                                                  |  | (in thousands) |      
| |                                                  |  |                |      
| |                                                  |  |                |      
| | Government
  departments and agencies            |  | $              | 336   |      | $ | 866   | 
| | Employees
  and wage-related liabilities         |  |                | 4,018 |      |   | 4,223 | 
| | Accrued
  expenses and other current liabilities |  |                | 2,570 |      |   | 2,296 | 
| |                                                  |  |                |       |      |   |       | 
| |                                                  |  | $              | 6,924 |      | $ | 7,385 | 
| |                                                  |  |                |       |      |   |       | 

F-58

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                                                       
|--------- | ------------------------------------------------------
|Note 15  | Supplementary Financial Statement Information (cont.):

|   |                           |                                                                                                                                                                                                                    
|-- | ------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|B. | Statements of Operations:
|   |                           |                                                                                                                                                                                                                    
|   | 1.                        | Principal Customers:                                                                                                                                                                                               
|   |                           |                                                                                                                                                                                                                    
|   |                           | One customer accounted for 17%, 15%, and 14% of the Companys
  revenues in 2005, 2004, and 2003, respectively, and 5.8%, 6.9%, and 8.7% of
  the Companys trade receivable in 2005, 2004, and 2003, respectively.
|   |                           |                                                                                                                                                                                                                    
|   | 2.                        | Financial Income (Expenses), Net:                                                                                                                                                                                  

| |                                                         |  |                         |        |      |   |      |   |   |      |  
| | ------------------------------------------------------- |  | ----------------------- | ------ | ---- | - | ---- | - | - | ---- | -
| |                                                         |  | Year ended December 31, |       
| |                                                         |  |                         |       
| |                                                         |  | 2005                    |        | 2004 |   | 2003 |  
| |                                                         |  |                         |        |      |   |      |  
| |                                                         |  | (in thousands)          |       
| |                                                         |  |                         |       
|
| | Interest income                                         |  | $                       | 191    |      | $ | 205  |   | $ | 109  |  
| | Foreign currency translation adjustments (see Note 1A4) |  |                         | (580   | )    |   | 69   |   |   | 614  |  
| | Gain on sale of marketable securities                   |  |                         | 247    |      |   | 164  |   |   | 105  |  
| | Interest expense                                        |  |                         | (898   | )    |   | (632 | ) |   | (663 | )
| | Debentures and convertible debt related expenses        |  |                         | (938   | )    |   | (688 | ) |   | -    |  
| |                                                         |  |                         |        |      |   |      |   |   |      |  
| |                                                         |  | $                       | (1,978 | )    | $ | (882 | ) | $ | 165  |  
| |                                                         |  |                         |        |      |   |      |   |   |      |  

| |    |                                        
| | -- | ---------------------------------------
| | 3. | Gain on
  Realization of Shareholdings:

| |         |  |                         |   |      |   |      |   |   |     | 
| | ------- |  | ----------------------- | - | ---- | - | ---- | - | - | --- | 
| |         |  | Year ended December 31, |  
| |         |  |                         |  
| |         |  | 2005                    |   | 2004 |   | 2003 |  
| |         |  |                         |   |      |   |      |  
| |         |  | (in thousands)          |  
| |         |  |                         |  
|
| | Level 8 |  | $                       | - |      | $ | 171  |   | $ | 376 | 
| | Tesnet  |  |                         | - |      |   | (59  | ) |   | -   | 
| |         |  |                         |   |      |   |      |   |   |     | 
| |         |  | $                       | - |      | $ | 112  |   | $ | 376 | 
| |         |  |                         |   |      |   |      |   |   |     | 

| |    |                     
| | -- | --------------------
| | 4. | Other
  Income, Net:

| |                                                                                 |  |                         |     |      |   |      |   |   |      |  
| | ------------------------------------------------------------------------------- |  | ----------------------- | --- | ---- | - | ---- | - | - | ---- | -
| |                                                                                 |  | Year ended December 31, |    
| |                                                                                 |  |                         |    
| |                                                                                 |  | 2005                    |     | 2004 |   | 2003 |  
| |                                                                                 |  |                         |     |      |   |      |  
| |                                                                                 |  | (in thousands)          |    
| |                                                                                 |  |                         |    
|
| | Gain (loss) on sale of property and equipment                                   |  | $                       | 35  |      | $ | (14  | ) | $ | (31  | )
| | Expiration of warrants in Tesnet (Note 3B)                                      |  |                         | -   |      |   | -    |   |   | 75   |  
| | Write-down of shareholdings in Transale                                         |  |                         | -   |      |   | -    |   |   | (100 | )
| | Write-down of loan to MultiConn Technologies (Note 2H)                          |  |                         | -   |      |   | -    |   |   | (350 | )
| | Decrease of provision for losses in formerly-consolidated subsidiary
  (Note 9) |  |                         | -   |      |   | -    |   |   | 541  |  
| | Dividend from Steps Ventures (Note 3D)                                          |  |                         | -   |      |   | 703  |   |   | -    |  
| | Other                                                                           |  |                         | 69  |      |   | 286  |   |   | 432  |  
| |                                                                                 |  |                         |     |      |   |      |   |   |      |  
| |                                                                                 |  | $                       | 104 |      | $ | 975  |   | $ | 567  |  
| |                                                                                 |  |                         |     |      |   |      |   |   |      |  

F-59

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                                                       
|--------- | ------------------------------------------------------
|Note 15  | Supplementary Financial Statement Information (cont.):

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|-- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|C. | Earnings Per Share:                                                                                                                                                                                                                                                                                                                                                                                                                                                  
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   | Basic earnings per share (EPS) was computed based on the average
  number of shares outstanding during each year, after giving retroactive effect
  to stock dividends and stock splits. In computing diluted EPS, effect was
  given to share options outstanding in each period, using the treasury stock
  method, provided that such effect is not anti-dilutive. The following table
  sets forth the computation of basic and diluted net earnings per share.

| |    |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
| | -- | ---------------------------------------------------------------------------------------------------------- |  | ----------------------- | ---------- | ---- | - | ---------- |  | - | ---------- | 
| |    |                                                                                                            |  | Year ended December 31, |           
| |    |                                                                                                            |  |                         |           
| |    |                                                                                                            |  | 2005                    |            | 2004 |   | 2003       | 
| |    |                                                                                                            |  |                         |            |      |   |            | 
| |    |                                                                                                            |  | (in thousands)          |           
| |    |                                                                                                            |  |                         |           
|
| | a. | Numerator:                                                                                                 |  |                         |            |      |   |            |  |   |            | 
|
| |    | Amount for basic earning per share  income available to
shareholders                                      |  | $                       | 1,789      |      | $ | 2,846      |  | $ | 1,851      | 
| |    |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
| |    | Effect of dilutive securities                                                                              |  |                         | -          |      |   | 276        |  |   | -          | 
|
| |    | Amount for diluted earnings per share  income available to
  shareholders                                 |  |                         | 1,789      |      |   | 3,122      |  |   | 1,851      | 
| |    |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
| |    |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
| | b. | Denominator:                                                                                               |  |                         |            |      |   |            |  |   |            | 
|
| |    | Denominator for basic net earnings per share - weighted average of
  shares                                |  |                         | 13,556,627 |      |   | 13,522,866 |  |   | 13,451,234 | 
| |    |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|
| |    | Effect of dilutive securities:                                                                             |  |                         |            |      |   |            |  |   |            | 
|
| |    | Employee share options                                                                                     |  |                         | 403,382    |      |   | 477,713    |  |   | 193,150    | 
| |    |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
| |    | Dilutive effect of issued debentures                                                                       |  |                         | -          |      |   | 678,447    |  |   | -          | 
| |    |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
| |    | Potential dilutive ordinary shares                                                                         |  |                         | 403,382    |      |   | 1,156,160  |  |   | 193,150    | 
| |    |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
| |    | Denominator for diluted net earnings per share - weighted average
  shares and assumed exercise of options |  |                         | 13,959,909 |      |   | 14,679,026 |  |   | 13,644,384 | 
| |    |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|
| |    | Basic net earnings per share                                                                               |  | $                       | 0.13       |      | $ | 0.21       |  | $ | 0.14       | 
| |    |                                                                                                            |  |                         |            |      |   |            |  |   |            | 
|
| |    | Diluted net earnings per share                                                                             |  | $                       | 0.13       |      | $ | 0.21       |  | $ | 0.14       | 
| |    |                                                                                                            |  |                         |            |      |   |            |  |   |            | 

| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Options to
  purchase 1,391,895, 1,318,817, and 1,067,000 shares at various prices between
  $4.5 and $10.5 per share were outstanding during the years of 2005, 2004, and
  2003, respectively, but were not included in the computation of diluted EPS
  because the options exercise price was higher than the average market price
  of the ordinary shares. In 2005, 952,381 shares underlying the convertible
  debentures and 140,000 warrants granted to FIMI were excluded from the
  computation of diluted EPS since their inclusion would have had an
  anti-dilutive effect on EPS.

F-60

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                                                       
|--------- | ------------------------------------------------------
|Note 15  | Supplementary Financial Statement Information (cont.):

|   |                               |                                       
|-- | ----------------------------- | --------------------------------------
|D. | Geographic Areas Information:
|   |                               |                                       
|   | 1.                            | Sales: Classified by Geographic Areas:

| |                               |  |                         |        |      |   |        |  |   |        | 
| | ----------------------------- |  | ----------------------- | ------ | ---- | - | ------ |  | - | ------ | 
| |                               |  | Year ended December 31, |       
| |                               |  |                         |       
| |                               |  | 2005                    |        | 2004 |   | 2003   | 
| |                               |  |                         |        |      |   |        | 
| |                               |  | (in thousands)          |       
| |                               |  |                         |       
| |                               |  |                         |       
| | USA                           |  | $                       | 17,423 |      | $ | 20,438 |  | $ | 18,520 | 
| | Europe
  (other than Denmark) |  |                         | 18,643 |      |   | 15,860 |  |   | 19,799 | 
| | Denmark                       |  |                         | 12,334 |      |   | 10,122 |  |   | 8,997  | 
| | Israel                        |  |                         | 7,991  |      |   | 8,353  |  |   | 3,986  | 
| | Other                         |  |                         | 2,556  |      |   | 2,413  |  |   | 3,038  | 
| |                               |  |                         |        |      |   |        |  |   |        | 
| |                               |  | $                       | 58,947 |      | $ | 57,186 |  | $ | 54,340 | 
| |                               |  |                         |        |      |   |        |  |   |        | 

| |    |                                                                             
| | -- | ----------------------------------------------------------------------------
| |    | Sales by
  geographic areas are determined based on the customers location.
| |    |                                                                             
| | 2. | The Companys Long-lived Assets Are as Follows:                             

| |                               |  |                |        |      |   |        | 
| | ----------------------------- |  | -------------- | ------ | ---- | - | ------ | 
| |                               |  | December 31,   |       
| |                               |  |                |       
| |                               |  | 2004           |        | 2003 |  
| |                               |  |                |        |      |  
| |                               |  | (in thousands) |       
| |                               |  |                |       
| |                               |  |                |       
| | Israel                        |  | $              | 17,718 |      | $ | 18,801 | 
| | U.S.A.                        |  |                | 9,028  |      |   | 4,491  | 
| | Europe (other
  than Denmark) |  |                | 3,118  |      |   | 579    | 
| | Denmark                       |  |                | 351    |      |   | 551    | 
| |                               |  |                |        |      |   |        | 
| |                               |  | $              | 30,215 |      | $ | 24,422 | 
| |                               |  |                |        |      |   |        | 

| |                                                                                                                          
| | -------------------------------------------------------------------------------------------------------------------------
| | Long-lived
  assets information is based on the physical location of the assets at the end
  of each of the fiscal years.
| |                                                                                                                          
| | The Company
  does not identify or allocate goodwill by geographic areas.                                                

F-61

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                                   
|--------- | ----------------------------------
|Note 16  | Transactions with Related Parties:

|                                                          |                                                                                             |  |                         |       |      |   |       |  |   |     | 
|--------------------------------------------------------- | ------------------------------------------------------------------------------------------- |  | ----------------------- | ----- | ---- | - | ----- |  | - | --- | 
|                                                          |                                                                                             |  | Year ended December 31, |      
|                                                          |                                                                                             |  |                         |      
|                                                          |                                                                                             |  | 2005                    |       | 2004 |   | 2003  | 
|                                                          |                                                                                             |  |                         |       |      |   |       | 
|                                                          |                                                                                             |  | (in thousands)          |      
|                                                          |                                                                                             |  |                         |      
|Formula, its subsidiaries and other associated companies: |                                                                                             |  |                         |       |      |   |       |  |   |    
|                                                          |                                                                                             |  |                         |       |      |   |       |  |   |     | 
|A.                                                        | Selling,
  general and administrative expenses: management fees (Note 11A2)                 |  | $                       | 180   |      | $ | 180   |  | $ | 180 | 
|                                                          |                                                                                             |  |                         |       |      |   |       |  |   |     | 
|B.                                                        | Revenues
  from sale of software conversion tool and software services to related
  parties |  | $                       | 1,694 |      | $ | 1,973 |  | $ | 225 | 
|                                                          |                                                                                             |  |                         |       |      |   |       |  |   |     | 
|C.                                                        | Cost of
  revenues relating to services from related parties                                |  | $                       | 1,761 |      | $ | 2,315 |  | $ | 354 | 
|                                                          |                                                                                             |  |                         |       |      |   |       |  |   |     | 
|D.                                                        | Reimbursement
  related to services rendered to affiliated and other companies              |  | $                       | 41    |      | $ | 235   |  | $ | 256 | 

|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|-- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|E. | Arie Kilman
  was nominated as the Companys Chief Executive Office in May 2003. In his
  former position as Lirazs chairman of the board of directors, he was granted
  in May 2002 a loan of approximately $300 thousand, linked to the Israeli
  Consumer Price Index, and bearing an annual interest at a rate of 4%. Under
  the terms of the loan, the loan should be repaid to Liraz in four equal
  annual installments, but no later than upon termination of Mr. Kilmans
  employment. Mr. Kilman pledged 200,000 of the Lirazs shares he owned in
  favor of the Company to secure repayment of the loan. Following the share
  exchange transaction between the Company and Lirazs shareholders effective
  as of November 14, 2002, Mr. Kilman replaced the pledged shares with 119,760
  of BluePhoenix shares. The amount of the Companys shares pledged by Mr.
  Kilman was based on the exchange ratio determined in the share exchange
  agreement, pursuant to which every 1.67 shares of Liraz were exchanged for
  one BluePhoenix ordinary share. Except for the replacement of the pledged
  shares, the terms of the loan were not amended. As of December 31, 2005, Mr.
  Kilman repaid $225 thousand of the principal amount of the loan plus linkage
  differentials and accrued interest. Accordingly, 75% of the pledged shares
  were released from the pledge. As of December 31, 2005, the outstanding
  balance of this loan was $96 thousand.
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|F. | As to the
  Companys acquisition of AlphaTech from Intercomp  see Note 2D                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|G. | In October
  2003, the Company entered into an option agreement with Intercomp to purchase
  Intercomps technology for an aggregate of $1.9 million. In addition, the
  Company undertook to pay royalties to Intercomp of 25% of the revenues
  generated from the purchased technology.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          

F-62

---

---



BLUEPHOENIX SOLUTIONS LTD.

(An Israeli Corporation)

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|          |                   
|--------- | ------------------
|Note 17  | Subsequent Events:

|   |                                                                                                                         
|-- | ------------------------------------------------------------------------------------------------------------------------
|A. | As to the
  amendment of the agreement signed with Outlook Systems  see Note 2F.                                       
|   |                                                                                                                         
|B. | As to the
  acquisition of Zulu  see Note 3A.                                                                          
|   |                                                                                                                         
|C. | As to a
  public offering in Israel of series A convertible notes  see Note 12B5.                                      
|   |                                                                                                                         
|D. | As to the
  exercise of institutional investors right to purchase additional debentures
  and warrants  see Note 12B4.

F-63

---

---